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Advisor Perspective

Advisor Perspective

Tax Aware Investing – Eliminate: Basis Adjustment at Death

Ryan Moran

Advisor, CFA, CPA, CFP®
Ryan combines his passion for the markets with an equally strong desire to help clients achieve their goals and objectives. He recognizes that his value as an advisor is found not only in results, but also in how he clearly communicates the multifaceted complexities of financial planning, investing, and taxation.

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JMG Financial Group takes a Tax Aware approach to investing by utilizing various tactics and techniques to Eliminate, Defer, or Reduce the impact of taxes on our clients’ financial situation.  This is the second article in a series on how to apply these strategies (What You Need to Know about Tax Aware Investing).

Let’s start at the end, so to speak, with the last tactic to use within Tax Aware Investing: eliminating tax burden using the “fresh start” basis at death. This may be uncomfortable to discuss, but like taxes, death is inevitable and should be considered during the financial planning process.

The Basics of Basis
When you purchase an asset, that initial investment amount is referred to as your cost basis in the asset.  With some assets (like rental real estate or business assets), that cost basis decreases over time due to depreciation or amortization where the cost is written off or expensed against the income that asset generates.

When you sell that asset, the capital gain (or loss) is calculated as the difference between the sales price and the cost basis.  If the sales price is higher than the cost basis, that difference is taxable as a capital gain.

Upon Passing
Currently, at death certain types of assets receive a “fresh start” in basis.  The cost basis of that asset is adjusted to its fair market value as of the date of death, which can result in either a step-up in basis or step-down in basis. The inheritor of the asset will use this “fresh start basis” when selling the asset.  In the case of a step-up in basis, this process essentially eliminates any capital gains tax embedded in the asset upon transfer to the inheritor.

For example, imagine your rich uncle had the foresight many years ago to purchase shares of XYZ Inc. for $1 a share.  Today, each share is now worth $100.  Unfortunately, your uncle passes away but fortunately for you leaves these shares to you as an inheritance.  When you sell these shares, the cost basis used to figure out the taxable capital gain is $100 a share, not the $1 a share originally paid.  Due to the current rules allowing for the step-up in basis, the $99 of capital gains are eliminated from tax.

There would be a peripheral benefit from this rule if your uncle had not kept records to substantiate the original purchase price.  The inheritor and estate executor will now have a defined cost basis to use and are not required to reconstruct the original cost basis.

What Investments’ Basis can be Adjusted?
Most assets receive the “fresh start basis” including securities in taxable brokerage accounts, real estate (both rental and personal), and privately held businesses.  With some of these assets, where a value is not readily available, an appraisal would be required to substantiate the current fair market value.

Some types of assets do not receive a basis adjustment including retirement accounts (such as a 401k, IRA, or Roth accounts) and tax deferred annuities.

Step-Down in Basis
The rules require that the cost basis be updated to the fair market value of the asset as of the date of death. It is possible that any specific asset may have a fair market value that is lower than the cost basis of the decedent.  In these cases, the cost basis is reduced and any deduction for a capital loss is forgone. If there is an opportunity, selling these loss shares prior to death could reduce taxes.

Opportunity Cost of Keeping a Highly Appreciated Investment

Sometimes investors are so determined to avoid a capital gain that they keep subpar investments for years or decades. These investments may have high fees, be trailing their peers, or be tax inefficient. Paying the tax and re-investing the proceeds in an investment which may perform better can be a superior solution.

How does Asset Titling Impact Eligibility to Step-Up Basis?
As you have already heard from your JMG Advisor, how you hold and title your accounts is an important decision that is often overlooked.

If an asset is titled directly in the decedent’s name or in a revocable or living trust it will receive the “fresh start” in basis upon death. However, assets that have been transferred to an irrevocable trust are not eligible since the decedent no longer owns them.

If an asset is titled jointly, such as between spouses, only half of that asset gets the “fresh start” in basis –the half owned by the deceased.  In this case, the surviving spouse adds the increase in basis to their cost.

Generally, an asset will receive the “fresh start” in basis if it would be included in the decedent’s estate.

Community Property
Rules and laws governing asset ownership are set by the state of residence.  Certain states, including Wisconsin, use a set of laws referred to as “community property” to govern asset ownership between married spouses.  Conceptually, this principle allows those assets, included as community property, to be concurrently owned 100% by each spouse.  Due to this nuance, in these community property states, the surviving spouse obtains a basis adjustment for all community property owned at the first death, not just half.  The basis for the same assets can be stepped up a second time upon the passing of the surviving spouse.  This is a very important distinction within the rules, again often overlooked.

Planning Opportunities
Although planning for the basis adjustment at death could be a troubling and uncomfortable discussion, the elimination of capital gains through the step-up in basis is a powerful technique and should be discussed with your JMG advisor.

Your advisor will help ensure accounts are properly titled as a part of the financial planning process.  There may be instances where proactive planning could create opportunities for assets to be moved between spouses, as long as they are not transferred back within a year.  Additionally, tax loss harvesting before death may make more sense than a step-down in basis.

Our financial planning services include helping after the passing of a loved one.  We can work with the executor or surviving spouse to assist with determining the date of death valuations, retitling assets and the disposition of assets to beneficiaries.  We also work with financial institutions to make sure their cost basis records has been updated properly.

Have questions?
Contact your JMG advisor who will be happy to talk through these issues with you and your attorney.

Notice: The elimination (or reduction) of basis adjustments is currently being discussed by Congress.  As of the publishing of this article, November 18th, 2021, it is still in effect.

Important Disclosure

Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this writing, will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio. Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this writing serves as the receipt of, or as a substitute for, personalized investment advice from JMG Financial Group, Ltd. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. JMG is neither a law firm nor a certified public accounting firm and no portion of the content provided in this writing should be construed as legal or accounting advice. A copy of JMG’s current written disclosure statement discussing advisory services and fees is available for review upon request.

To the extent provided in this writing, historical performance results for investment indices and/or categories have been provided for general comparison purposes only, and generally do not reflect the deduction of transaction and/or custodial charges, the deduction of an investment management fee, nor the impact of taxes, the incurrence of which would have the effect of decreasing historical performance results. It should not be assumed that your account holdings correspond directly to any comparative indices. Indices are not available for direct investment.