As seniors decide to downsize and settle down to an easier life, one of the ideas that often crosses their minds is beginning to distribute their assets before their death to their children, including their house or other real estate, stocks, bonds, and mutual funds. Often times, the seniors believe that by doing this their children will not have to burden themselves with a lengthy and costly estate administration process, or that by transferring their house to their children before entering a nursing home means that the house is protected and will not have to be sold to pay for the costs of skilled nursing care. Although their hearts are in the right place, their decisions may have some costly tax consequences.
Rather than gifting your assets to your children, grandchildren, or others, outright during your lifetime, appropriate planning should be considered and often utilized to reduce the amount of capital gains ultimately paid by the next generation.
The term “step-up in basis” references the adjustment that is made based upon the difference between an asset’s current value and its value at the time it was purchased (a.k.a. cost basis). Explained another way, a “step-up in basis” is a lawful adjustment that occurs when certain assets are transferred as the result of someone’s death. Often times, the fair market value of an asset at a person’s death (“the date of death value”) is much higher than the cost of that same asset when the deceased person bought the asset (“the cost basis”). When a person waits to transfer certain assets until that person’s death, those assets receive a “step-up in basis” thereby increasing “the cost basis” to “the date of death value.” Since the “cost basis” is what determines the taxes owed when the asset is sold, by increasing the cost basis to the date of death value through a “step-up in basis”, the capital gains taxes owed on that asset is either wiped out completely or minimized if the asset is sold at a higher price later. This concept applies to real estate, stocks, bonds, and mutual funds, amongst other possible assets. To better illustrate this concept and its potential significant impact, please consider the example used below:
Susan owns a cottage that she bought for $100,000 in 1984. The cottage is now worth $1,000,000. If Susan were to sell this cottage today, for fair market value, her profit would be $900,000 and Susan would then pay capital gains tax on the profit value ($900,000).
Now, imagine that Susan wants her son, Sam, to inherit this cottage after she passes. Sam would benefit from the fact that his mother passed on this asset as part of her estate distribution and not while she was alive. This is because after Sam inherits this cottage, his cost basis would be $1,000,000 (the fair market value at the time of Susan’s death). If Sam then sells the cottage for its current value of $1,000,000 after his mother’s death, then Sam would not pay any capital gains taxes because Sam would receive that “step-up in basis” on this asset and, as a result, his capital gains would be $0. Compare that scenario to a scenario where Susan decided to transfer the cottage to Sam while she was alive, and then Sam decides to sell it for its fair market value shortly after his mother’s death (using this example, $1,000,000), Sam would be responsible for paying the capital gains taxes on the profit value of $900,000, which would result in $135,000 to $180,000 of tax (depending on tax bracket) to be paid by Sam which could have been completely avoided if Susan just delayed the transfer of the cottage until the time of her death. Thus, the concept of “step-up in basis” works to reduce and minimize the capital gains tax owed by the recipient, who are often heirs of the decedent.
The “step-up in basis” rules play a crucial role in estate planning, especially when thinking about minimizing capital gains taxes on inherited assets. Understanding how the “step-up in basis” works and applies to various assets is extremely important for a senior to know and understand and allows those individuals seeking to transfer assets to do so in a manner that transfers more wealth to the intended recipient (and does not negatively affect the senior making the gift).
Step-up in basis should be distinguished from the concept of carryover basis. A carryover basis refers to the cost basis of an asset when one party leaves assets or property to another as a gift. When this occurs, the basis remains equal to the basis that was held by the donor of the gift. The biggest difference between step-up in basis and carryover basis is that the former is used when the asset is inherited after the death of the donor. However, the latter is used during the lifetime of the donor.
If you would like to discuss the concept of the “step-up in basis” with an attorney, please contact the attorneys at Pullano & Farrow and reference this legal briefing. noted in our prior Legal Briefing from January, 2024 (https://www.lawpf.com/post/new-york-covid-19-sick-leave-new-developments), Governor Hochul’s Fiscal Year 2025 Executive Budget proposed to eliminate New York’s existing COVID-19 Sick Leave Law that required covered employers to provide sick leave/paid family leave and related benefits for employees who have been subject to a mandatory or precautionary order of quarantine or isolation due to COVID-19.
While the final version of the Executive Budget did eliminate the COVID-19 Sick Leave Law, the existing benefits will not expire until July 31, 2025, instead of the originally proposed July 31, 2024 date.
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This Legal Briefing is intended for general informational and educational purposes only and should not be considered legal advice or counsel. The substance of this Legal Briefing is not intended to cover all legal issues or developments regarding the matter. Please consult with an attorney to ascertain how these new developments may relate to you or your business. ©2024 Law Offices of Pullano & Farrow PLLC