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Monday, March 7, 2011

Why a step-up in cost basis can affect taxes

A step up in cost basis can dramatically affect taxes because it amounts to an increase in the value of wealth passed between deceased and living persons. The step up in cost basis regulation is contained within Title 26, Subtitle A, Chapter 1 of the U.S. code alternatively named the I.R.S. tax code. This regulation requires property to be adjusted to fair market value following the death of the owner, but is capped at no more than $1.3 million in so far as the tax code permits.

Major disadvantages of step ups in cost basis is the amount of wealth that is taxed either via inheritance tax, or estate tax. An advantage however, is that realized capital gains can shrink lowering the resultant capital gains tax for the beneficiary responsible for liquidating the property.  Even with a reduction in capital gains tax however, the step up in cost basis ends up making an estate and inheritance cost more. Since inheritance and estates are sometimes taxed, the affect can still increase the amount of taxes due.

The step up in cost basis is an important aspect of estate tax planning and individual tax strategy. Being aware of how it can affect taxes and the methods by which it may be reduced or beneficial is key to making the most of this financial requirement. Estate planning is particularly relevant to step ups in cost basis because the financial instrument in which wealth is held and through which it is transferred affects how the property will be taxed regardless of the step up in tax basis.

Several financial instruments may be utilized to bypass immediate estate, capital gains and inheritance taxes. Examples of these estate planning tools include family limited partnerships, various forms of trusts, and gifting.  Although not all financial instruments avoid taxation, they can defer taxation until a suitable tax strategy has been developed. When estates are valued below a certain amount, neither the estate or inheritance tax may be applicable making a split estate an option to consider.

Depending on which state a beneficiary or beneficiaries live, the step up in cost basis may affect taxes differently. For example, not all U.S. states have an inheritance tax. Inheritance and estate tax may in some cases be avoided when held in joint tenancy. Since two or more persons own the property, the property does not transfer and is therefore not an inheritance per se because it is already owned.

As tax regulations are updated and changed, the step up basis on assets can affect taxes differently. For example, in 2010 the estate tax rules are set to expire thereafter reinstating the taxation of estate value. Specific taxes to be aware of when it comes to step ups in cost basis are capital gains tax, inheritance and estate tax, in addition to value limits and caps on transactions relating to such. These taxes can reduce the value of an estate significantly. Navigating the tax strategy and financial options with a skilled and knowledgeable financial professional may be of great value in some circumstances.

Sources: 

1. http://bit.ly/c2ncMG (Cornell University Law School)
2. http://bit.ly/cRsFXK (Estate Find Law)
3. http://bit.ly/c0XnQo (Bankrate.com)
4. http://bit.ly/auDihg (Avoid probate.com)