Different Basis Treatment: Lifetime Gift vs. Death Transfer
There are two main ways in which property is transferred from one individual to another: by death and by a lifetime gift. Interestingly, the recipient’s basis in the transferred asset is different in each situation and results in varying tax consequences. Failing to understand the difference can result in capital gains taxes for the recipient of the property that may otherwise be avoidable.
Property Transferred by Death: Step-Up in Basis
When property is transferred by the death of the prior owner, the recipient acquires the date-of-death value of the property as his or her basis in the property. Basis is the original cost of acquiring an asset.
For example…
Father bought a home for $100,000, which becomes his basis. When Father dies, his executor transfers the home to Daughter per his will. At the time of Father’s death, the value of the home is $200,000. When Daughter takes title of the home, she acquires a step-up in basis. Her basis in the home is the $200,000 date-of-death value of the home.
This means that if Daughter sells the home the next day for $200,000, she won’t be liable for any capital gains tax because the value of the home minus the basis in the home is zero.
Community Property Step-Up in Basis:
Husband and Wife own a home as community property. They bought the home for $100,000, which is their basis. When Husband dies, the value of the home is $200,000. The entire home gets a step-up in basis to the value as of the date of death - $200,000.
While most assets (stocks, bonds, mutual funds, businesses, equipment, real estate) receive as step-up in basis on death, not all property is eligible for a step-up in basis. Assets like IRAs, 401(k) accounts and pensions, tax deferred annuities, and certificates of deposit are not eligible for a step-up in basis.
Transferring property by death can be tax-advantageous to both prior owners and recipients because it ensures that no one pays taxes on the capital gains accrued during the prior owner’s lifetime. It’s a win-win! However, retaining ownership of an asset until death ensures that the asset will be included in the prior owner’s estate, and it may be liable for estate taxes, so there can be significant drawbacks for death transfers depending on the size of the transferor’s estate.
Property Transferred by Gift: Carryover Basis
While the tax benefits of a step-up in basis are substantial, other estate-planning goals may outweigh the need to avoid capital gains taxes on a property. For instance, an important tool for decreasing the value of a person’s estate (and therefore his or her estate tax liability) is giving gifts during the person’s lifetime whether outright or in trust.
When property is transferred by gift during the gift-giver’s lifetime, the recipient acquires the giver’s basis in the property. The value of the asset on the date of gift is irrelevant.
For example…
Father owns a home that has a basis of $100,000. Father gifts the home to Daughter during his lifetime. At the time of the gift, the value of the home is $200,000. When Daughter takes title of the home, she acquires Father’s basis in the home. Her basis in the home is $100,000.
If Daughter sells the home the next day for $200,000, she’ll be liable for capital gains tax on $100,000 (the value of the home minus the basis in the home).
It is important to remember that any gift valued over the annual gift tax exclusion ($18,000 in 2024) is a taxable gift and must be reported to the IRS.
However, there are many different tax-minimizing strategies that may negate the concerns of gift tax liability and imposing capital gains liability on the recipient such as giving to individuals in lower tax brackets and taking advantage of tax breaks for a primary residence.
Call us at (512)374-4922 to talk to our estate planning attorneys about the best way to transfer your assets to avoid unnecessary gift, estate, and capital gains taxes!