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Capital
Gains Reduction
by
James Lange, CPA, Attorney at Law
The "free step-up-in-basis concept" has broad implications
in the income-tax and estate- planning area. This article explains
both the basic concept of "step-up" and the recent favorable
holding that expands the rule.
Gallenstein,
975 F.2d 286, has important implications for establishing the tax
basis of property that was jointly owned by husband and wife before
1977. For those taxpayers who have already disposed of the property,
they should consider filing amended tax returns which could possibly
result in significant refunds. If the property is still owned by
one or both spouses, Gallenstein could present important
implications for planning the disposition of the asset and significant
estate-planning opportunities.
Before
we get to the nuances of Gallenstein, it is best to start with an
explanation of the step-up-in-basis concept. Understanding this
concept will benefit many taxpayers.
Basic
Free Step-Up-In-Basis Rules
Step-up-in-basis
means that the basis of an asset is increased to ITS fair market
value at the date of death.
Example:
Assume there is a parcel of vacant land that a taxpayer, hereafter
T, has purchased for investment. T bought the land for $10,000 in
1970. The parcel would now sell for $100,000 after costs and commissions.
If T sold the parcel tomorrow, he would have to pay $25,200 in income
taxes on the $90,000 capital gain. ($100,000 proceeds, less $10,000
cost basis = $90,000 capital gain times 28% tax rate = $25,200.)
Now
assume that instead of selling the land, T holds the property. Then,
T dies leaving the piece of land to his child through his Will.
Then, assume the child sells the property one day after T dies.
What is the gain to the child?
If
you said $90,000-gain and $25,200-tax, you are thinking logically,
but your answer is wrong. The right answer is: the child would pay
no income taxes. The child will receive a free "step-up-in-basis"
for the property. The child's basis became the fair market value
of the land at the date of death of T, the owner. Since the value
of the property is $100,000 on the date of death, and was sold for
$100,000, T's child would pay no capital gains tax because of the
step-up-in-basis rules.
In
fact, nobody paid capital gains tax on the $90,000 appreciation
of the land. Thank you, Uncle Sam.
Estate
Planning Tip: T is near death. His estate consists of one parcel
of vacant land he bought for $10,000 that is now worth $100,000.
Should he sell it, keep it, or should T hold the property during
his life and leave the property to an heir, and let the heir sell
it?
If
T would give the property to the heir before he died, the heir's
basis would be the same as T's basis: $10,000. This is known as
the carryover basis. The general rule is that the basis of property
to a donee is the same as the donor's basis. Thus, if there was
a gift, T's donee would pay $25,200 in capital gains tax.
Note
that this is different than the "step-up" that occurs
only after T's death. Holding the property until T's death would
give the heir a $100,000 basis. The heir could then sell the property
and save the $25,200 in capital gains tax.
Comment:
I cannot tell you how many taxpayers unwisely transfer appreciated
property to an heir to avoid inheritance taxes. The result of this
inexperienced estate planning often means greatly increased capital
gains tax for the unsuspecting heir.
If
you understand the basic step-up-in-basis rules, you are ahead of
most taxpayers. The step-up-in-basis rules apply to stocks, bonds,
investments, real property, personal property, houses, and property
a taxpayer owns.
Step-Up-in-Basis
in Jointly Owned Property Between Husband and Wife
Let's
take it another step. Assume T bought the property in 1970 for $10,000
and later transferred it to jointly-held property with his wife
in 1976. Then, T died and his wife received the property by operation
of law because she is the surviving joint owner. Assume that the
property was included in T's estate. There would be no estate tax
because of the unlimited marital deduction (another subject, another
day). Then, assume T's wife sold the property for $100,000. What
is her taxable gain?
Old
Law: T's wife would be able to step-up only one-half of the
property. Her gain would be $45,000, calculated as follows:
| 1/2
times the original basis of $10,000 |
$
5,000 (wife's share of basis after gift) |
1/2
times the date of death fair
market value of $100,000 |
50,000
(wife's share of inherited portion, partial step-up) |
| Total
basis |
$
55,000 |
| Proceeds |
$100,000 |
| Less
basis |
(
55,000) |
| Gain |
$
45,000 |
New
Law According to Gallenstein
T's
wife would get a 100% free step-up-in-basis. Assuming she sold the
property for $100,000, she would pay no income or capital gains
tax. In effect, nobody paid tax on the $90,000 gain.
| Total
proceeds |
$100,000 |
Less
full step-up-in-basis |
(100,000) |
| Taxable
gain |
$
-0- |
There
are, however, pitfalls of relying on Gallenstein in all instances.
A complete discussion would involve a thorough analysis of the case
and the history and interpretation of Internal Revenue Code Section
2040. One of my assumptions in this example is that the full value
of the property would be included in T's estate. While this is generally
true, T's estate would usually utilize the marital deduction. Caution
is advised. Great opportunities, however, exist. Gallenstein
received a refund of over $115,000.
It
is also important to note that the IRS is likely to reject Gallenstein.
It is, however, the finding of the United States Court of Appeals,
Sixth Circuit, the highest court to address this question.
Conclusion
An
understanding of the basic free step-up-in-basis rules is critical
for attorneys involved with estate planning or estate administration.
Utilizing the free-step-up-in-basis rules to apply in situations
like Gallenstein has significant risks, but significant rewards.
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