As you do your estate planning, it's important to understand the "income tax basis"  that your heirs receive when they inherit property.  Traditionally, estate planning has focused on reducing estate taxes and avoiding probate.  However, since the estate tax exemption is currently $5.49 million ($10.98 million for married couples), those who need to concern themselves with avoiding estate taxes are fewer than ever before.

However, everyone is subject to taxation on income and capital gains -- and California leads the nation in both income and capital gains tax rates. Understanding the basics about "step-up in basis" tax rules is key to minimizing income, and capital gains.

The Basics of Basis

Typically, the basis of property you purchase is its cost.   When someone inherits property, the basis is typically either the fair market value of the property on the day the decedent died, or the fair market value on the alternate valuation date (six months after death).  The estate executor makes the decision on whether or not to use alternate valuation. 

Using fair market value basis rules -- also known as the "step-up and step-down" rules -- an heir inheriting property receives a basis that is equal to the value of that property on the decedent's death date.  For example, if a person purchased Apple stock in 1980 for $5,000 and it was worth $5 million on the day he died, his heirs receive the step-up in basis to $5 million and the gain is not subject to income tax.  

However, if he were to make a lifetime gift of the stock to those same heirs, the step-up in basis would be lost.  Any property acquired via a lifetime gift is subject to carryover basis rules, meaning that donees of a gift receive the same basis as the donor (i.e., $5,000 using the Apple stock example) plus a portion of any gift tax paid by the donor.

If the value of the stock had declined, the heirs would receive a step-down in basis where the basis is lowered to the value at the date of death. 

Impact of Community Property on Basis

California assets held as community property are eligible for a "double step up in basis" where the basis adjusts to the entire value of the asset at the first spouse's death. Therefore, how title is held, and the timing of transactions can be critical to the amount of income and capital gain realized and recognized.

Understanding the complicated world of tax consequences and figuring the right options for your family demand the counsel of an experienced attorney. If you have any questions, contact HMS Law Group LLC at (916) 252-0200.