Putting off paying taxes as long as possible is an American pastime; for some even a passion. The time value of money teaches us that a dollar of tax paid next year is much cheaper than a dollar of tax paid today. In general, taxpayers and their heirs want to put off the ‘recognition of gains’. What might happen if we can’t put off payment any longer?
An interesting twist on the notion of ‘income’ is the capital gain. This matters in estate planning because of the way capital gains are handled when someone dies. Income which is a ‘capital gain’ is the difference between what you paid for something (your ‘basis’) and the net revenue you receive when you sell that something. All kinds of special tax rules apply to this sort of income – including different rates, holding times, and – important for today’s discussion – treatment after death. Before an asset is sold and the capital gain income is measured, the potentiality is called ‘appreciation.’ Appreciation is how much an asset increased in value since you bought it.
Under current law, when you die and leave appreciated assets to your heirs, they get a tax benefit known as a ‘step up’ in basis. This means that the value of the asset on the date of your death is your heirs’ new basis in the asset, regardless of what you paid for it. Essentially, when you die, current law ignores the appreciation on the asset during your life. This rule provides two important benefits to your heirs. First, when they sell the asset, the capital gain income is measured from the value on the date of your death, so they are paying less income tax on the capital gain than you would have if you had sold that asset while you were alive. Second, if the asset can be ‘depreciated’ (which is a fancy way of saying it gives you an annual income tax break just for owning it), a higher starting basis gives you a larger deprecation amount, so you get more annual tax benefit.
This rule also gives the government and taxpayers an additional benefit, which is that each party (e.g., the taxing government and the taxpayer) knows with clarity and reasonable certainty what the basis number is that future tax burdens and benefits are calculated from.
I appreciate you putting up with my definitions so far. Hold on a bit longer and I hope you will see where I’m taking you. This benefit of the stepped-up basis at death has a big tax-negative for the government, which is that the ability to tax the appreciation disappears at death, never to return. This leads to substantial lost revenue for the government.
Now imagine that a government wanted to capture that capital gains tax revenue. Conceivably, they could assess a tax on appreciation during someone’s life and prior to a voluntary sale. But there are a lot of problems for the taxing authority in that scenario. At least two obstacles are first, a fight with the taxpayer over the measure of the appreciation; and second, actually collecting the tax without forcing the taxpayer to sell the asset so that the taxpayer has the money to pay the tax.
It would be much easier for the taxing authority to demand payment of tax on the appreciation at the death of the owner, when the owner won’t be needing to use the asset anymore. The only obstacle remaining is measuring the appreciation.
Currently, you and after you, your heirs, can put off selling an asset – and thus triggering the tax – as long as YOU want to. But a government might put rules in place that would force some recognition of gain at death, which would either have to be paid out of cash in an estate, or the heir’s own pocket if the heir wanted to keep the appreciated asset. Over the years, Congress has debated this sort of action, either eliminating the step up in basis, or taxing capital gains at death. However, to date, no such changes have been made.
At the Law Offices of Mark E. Lewis & Associates, we plan estates carefully to maximize the benefits of the step up in basis at death. This includes thoroughly reviewing the manner in which title to assets are held, as well as creating trusts and other structures for our clients that can take the best advantage of the law on avoiding or deferring tax on capital gains income. If the law changes, we are ready to meet the challenges that will arise so that our clients can pass on the best benefit of their wealth to future generations. Call us to set an appointment to discuss these issues in light of your current estate plan and the challenge of future changes to the law.