Friday, April 3, 2015

What Every Investor Needs to Know About Basis

Until recently, when estate planners wanted to impress their clients, they offered strategies to save estate tax. Now, all the buzz is about maximizing basis and minimizing capital gains--maneuvers drawn from the income tax playbook.

About the Author Lawyer and award-winning journalist Deborah L. Jacobs covers personal finance, careers, and life transitions. She is the author of Estate Planning Smarts: A Practical, User-Friendly, Action-Oriented Guide. Combining real-life stories with practical advice, Deborah has addressed audiences of consumers, students, and professionals. Twitter: @djworking.Contact Author | Meet other investing specialists

When you sell an asset such as stock, you owe capital gains tax on the difference between the sale price and what you paid for it--your cost basis. But if you inherit certain assets, including marketable securities, you can "step up" their tax basis to whatever they were worth at your benefactor's death. That means highly appreciated inherited stock can be sold immediately with no capital gains, or later, with all the gains before you inherited it not counted. (Basis doesn't matter until there's a sale.)

Step-up isn't new, but it became more important after the legislative deal that Congress passed in 2013. It made permanent a generous exclusion from estate and gift tax. Currently, we can each transfer $5.43 million during life or at death, before a transfer tax of 40% kicks in.
In the same tax bill, Congress raised the top rate on long-term capital gains. Including a 3.8% net investment income tax, it is now 23.8%, an increase from 15% in 2012. And that's not counting state income tax, if you live in a state that has one.

Know Your Options
How does this play out in estate planning? Let's say the six-year bull market has left you holding publicly traded stocks that have appreciated. If you sell them, you will need to reckon with the dreaded capital gains tax. By all means, sell if you need to raise cash or diversify, or if it's otherwise a smart investment move (for instance, if the company seems headed for a downturn). But if you can afford to hang on to those stocks, your heirs can benefit from the basis step-up.

Another option is to give them an advance on their inheritance. In that case, there's no step-up--their basis is the same as yours. Unless recipients are in a lower tax bracket, they will have a big tax bill, too, if they sell appreciated stock. (Note that you can't give away a loss, so if asset values have gone down, you should sell the stock, book the loss and give away the proceeds.)

When making lifetime gifts, you must also keep in mind the gift tax rules. Without eating into the $5.43 million per person exemption, you can use what's called the annual exclusion, which allows you, each year, to make gifts of up to $14,000 (in cash or other assets) tax-free to each of as many people as you choose. Your gifts are counted at their fair market value.

If none of these possibilities sounds appealing, here are ways to minimize capital gains tax.

Donate to Charity
Since you're not selling the stock--just giving it away--you don't have to pay capital gains tax. And if you still want your portfolio to include that stock because you think it will continue to do well, you can buy additional shares at the higher price, notes Howard M. Zaritsky, a lawyer in Rapidan, Va. Those shares will have a higher basis than the ones you donated.

What's more, for gifts of marketable securities to a public charity, donors are entitled to an income tax deduction for up to 30% of adjusted gross income if they held the stock for more than 12 months. Your deduction is equal to the full market value of the securities--not what you paid for them. Any deduction that cannot be taken in the year of the donation can be carried forward up to five years.

Convert a Traditional IRA to a Roth
These accounts are among the best tax-planning tools available, says Paul S. Lee, a wealth manager with AB Bernstein. You must pay income tax on the amount you are converting; but after that, subject to certain restrictions, no income tax is assessed on distributions--by you or your heirs. "In effect, you are leveraging a tax cost today for an infinite amount of basis" going forward, Lee says.
What's more, any withdrawals--by you or your heirs--don't get added to taxable income. So, under current rules, it won't push any of you into a higher tax bracket that might require payment of extra Medicare premiums or the 3.8% surcharge.

Make Joint Assets Community Property
Married couples who live in a community property state (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin) have a basis advantage, says Wendy S. Goffe, a lawyer with Stoel Rives in Seattle. Unless you formally agree otherwise, most of what you acquire once you are married and living in one of these nine states is community property, and you are each considered a one-half owner. Therefore, when the first spouse dies, both halves of the property get a step up in basis. This minimizes capital gains tax if the surviving spouse sells the property.

Couples who don't live in a community property state may be able to achieve the same result by putting assets in what's called a joint revocable trust in the state of Alaska or Tennessee. In these states, community property is not automatic, but you can "opt in" to it if you live there or if you set up a trust there with a local trustee (for example, from a bank or trust company).

Community property trusts don't come cheap. There are set-up charges, and fees of professional trustees and investment managers. Plus, it will cost $500 to $1,500 yearly to have the trust tax return prepared. But the potential capital gains tax savings can be substantial, Zaritsky says. These trusts probably aren't a good idea for young, healthy spouses with high-basis assets, but they could work well for those who are old or infirm and who own low-basis assets that are likely to be sold soon after the first spouse dies.