The long-dreaded federal estate tax is no longer a beast it used to be. It's not dead, mind you, but at least these days the estate tax isn't causing such a fuss as in recent history. On the other hand, there is another less obvious tax monster that you can’t afford to ignore: the capital gains tax.
The reason for the pivot from estate tax to capital gains tax has everything to do with the budget deal of January 1, 2013, which locked in a high estate tax exclusion amount and confirmed the ability for spouses to pass unused estate tax exemption amounts between themselves (so called “portability”). In the same swoop, though, the maximum capital gains tax rate jumped up to 23.8% from the previous 15%. By comparison, the PA inheritance tax rate for property passed at death to children or grandchildren is only 4.5%.
So how does the capital gains tax impact your estate planning? This is a question Forbes explored in a great recent article (intriguingly) titled “Freebasing Your Estate.”
The key factor when it comes to capital gains tax is “cost basis,” which refers to the value against which the asset’s present/sale value is compared to determine the taxable gain. Usually, the cost basis is the original purchase price, sometimes with a few adjustments. A “postmortem” (at death) bequest and an “intervivos” (during life) gift can both transfer an asset with the same present value – but these two methods of transfer result in different treatment of the asset’s cost basis as it shifts from the donor to the recipient.
In the case of a transfer at death, the inheritor receives the asset with a cost basis equal to the asset’s “date of death” value. This is known as a “step up” in basis, since the basis “steps up” from the (usually lower) original basis value held by the donor to the present value of the asset. In the case of a lifetime gift, the recipient receives the asset with the original cost basis that was held by the donor. This is known as a “carryover” basis.
This becomes significant when the recipient wants to sell the asset, since the difference between the cost basis and the sales price will determine the amount of taxable capital gain on the sale. Assets transferred at death with a “stepped up” basis experience little, if any, capital gain when the asset is sold. Lifetime gifts with a carryover basis, however, can generate significant capital gains, especially if the gifted asset had appreciated greatly since it was originally purchased by the donor. In some cases, the capital gains tax on these lifetime gifts will be far higher than the Pennsylvania inheritance tax that would have been due if the assets had passed by Will or Trust.
With the federal estate tax now a non-issue for most of the population and the relatively low Pennsylvania inheritance tax rates, in many cases it may make more financial sense to transfer an asset at death rather than during your lifetime, all other considerations being equal.
So if you’ve been thinking about giving away assets to your children or to others during your lifetime to “avoid death taxes” and you’d like to pay make sure you’re not inviting higher taxes, you need to consult with your advisors to determine which method of transfer makes the most sense. For more information or to discuss your specific planning questions, contact us at Peak Legal Group to schedule a complimentary Estate Planning Consultation.
Reference: Forbes (February 12, 2014) “Freebasing Your Estate”