Things You Need to Know About Basis

“Basis” is a term used frequently in tax law. Black’s Law Dictionary defines basis as “the value assigned to a taxpayer’s investment in property and used primarily for computing gain or loss from a transfer of the property. When the assigned value represents the cost of acquiring the property, it is also called cost basis.

If you own an acre of land that you purchased 20 years ago for $10,000, generally speaking, the land’s basis is $10,000, the amount you paid for it. If you were to sell the property today for $100,000, you would realize a gain of $90,000. You would be required to report the gain to the Internal Revenue Service and your state tax authorities as capital gains on your 2021 income tax returns. That gain is typically subject to federal, and possibly state, capital gains taxes (depending on your state of residence).

State capital gains tax rates vary from state to state, and federal capital gains tax rates range from 0-20 percent, depending on a variety of factors associated with the forms and amounts of your other income.

On the other hand, if you could only sell the property for $5,000, you may be able to report the sale as a capital loss that could be used to offset capital gains realized on other assets that you may have sold. If you are actively buying and selling investments, your tax advisor is the person best suited to help you determine how to manage your capital gains and losses to achieve the best tax results available from year to year.

What is stepped-up basis?

Stepped-up basis is an important tax concept for estate and tax planning purposes. Section 1014 of the Internal Revenue Code provides that a person who inherits property that was included in the decedent’s estate obtains a new basis for the property that is equal to the fair market value of the property as of the decedent’s date of death. Therefore, an individual who inherits property can sell it and pay little to no capital gains taxes, resulting in significant tax savings for families who intend to pass on highly appreciated property such as land, company stock, or a family business, instead of selling or gifting it during their lifetimes.

So in the example above, if you died, leaving your one acre of land to your only child in your will or trust, and the value of the property at your date of death were $100,000, your child’s basis in that property at your death would be $100,000. If your child were to sell the property for cash the day after you die for $100,000, there would be no additional capital gains because the property did not increase in value between the date of your death and the sale of the property and, therefore, no capital gains taxes would be due.

What is carry-over basis?

Property that is transferred as a lifetime gift from the property owner directly to an individual or to an irrevocable trust for the benefit of another person results in a “carry-over” basis, meaning that the gift recipient’s basis is the same as the giver’s basis.

So, if before you die you were to deed your one acre of property in the example above to your child or to an irrevocable trust for the benefit of your child, the basis for that property remains the same as it was when you owned it ($10,000). If your child were to hold onto the property for some time after you die and then later sell it, they will still have your $10,000 basis in the property. Any gain above the $10,000 basis would be subject to capital gains tax.

Why are people talking about basis right now?

Various ideas have been proposed in recent months exploring the idea of eliminating the step-up in basis rule, or at least modifying it significantly, in an effort to increase tax revenues on property passing from generation to generation. If this proposed legislation becomes law, the estate planning landscape will change dramatically, creating a need for many individuals and families to revisit their planning with their legal and tax professionals.

Should you be worried?

It is too early to tell whether proposed legislation altering basis rules will make its way through Congress. There is much debate from all sides regarding such changes. If these proposed changes were signed into law, tax and estate planning advisors will be working diligently to find creative and effective tax-minimization solutions for their clients. Please schedule time to meet with us if you have any questions about how we can help you prepare for the uncertain future.