All About That Basis
I truly hope you’ve never had the unfortunate experience of listening to Meghan Trainor’s single “All About That Bass” released some 10 years ago. But when it comes to taxes on non-retirement accounts, it IS all about that BASIS. What is “basis” and how does that apply to taxes, charitable giving, and even where you choose to live? Let’s take a look!
What is Cost Basis?
Let’s start with the basics. Cost basis is the original value of an asset for tax purposes, which is usually the purchase price. This value is then adjusted for stock splits, dividends, and return of capital distributions. Knowing your cost basis is crucial for calculating capital gains or losses when you sell the asset and, ultimately, your tax burden.
Step-Up (or Step-Down) in Basis Upon Death
When someone inherits an asset, the cost basis is typically “stepped up” to its fair market value at the date of the decedent’s death. This can significantly reduce capital gains taxes once the asset is sold. However, in some cases, the basis can be stepped down if the asset’s value has decreased.
Gifting Assets: High vs. Low-Cost Basis
When gifting assets to family or friends, it’s generally best to gift those assets with the highest cost basis. This minimizes the recipient’s potential capital gains tax. Conversely, it’s often better to hold onto assets with a low-cost basis until death, so family and friends can benefit from the step-up in basis upon death.
On the other hand, if you are gifting to charities, it is usually more beneficial to gift assets that have experienced greater appreciation (and, as such, have a lower cost basis).
Where You Call Home Matters – Cost Basis Upon the Death of a Spouse
Working with clients on the West Coast, we have an intimate look at differences in the application of state property and tax laws. In the US, most states are “common law” states where assets are deemed to be owned equally (50/50) between spouses. Oregon is one of the common law states.
Washington and California, on the other hand, are “community property” states. In community property states, 100% of eligible assets are “stepped up” when either spouse passes away.
Let’s look at an example. Harry and Hank (twin brothers) are married to Wanda and Winifred (twin sisters), respectively. They are alike in all respects, except that Harry and Wanda live in Washington, while Hank and Winifred live in Oregon.
The couples are in their 80s and have a net worth of $4 million ($1 million in primary residence with a basis of $250,000, $1 million in non-retirement accounts with a basis of $500,000, and $1 million each in IRAs).
Harry and Hank pass away at the age of 85. Here’s where the outcomes for Wanda and Winifred are different.
Wanda benefits from Washington’s Community Property laws. The home and non-retirement accounts are “stepped up” to current market values ($1 million for both the residence and the non-retirement investments). The IRA accounts would not be stepped up due to the nature of the assets (but this is also true for Winifred in Oregon).
As a result of the change in basis, Wanda could sell the residence and the investment accounts and not have to pay capital gains.
Winifred, on the other hand, would receive only a partial step up in basis. If the residence originally were at $125,000 in Winifred’s name and $125,000 in Hank’s name, the resulting cost basis following Hank’s death would be $625,000 ($125,000 for Winifred and $500,000 for Hank). If she sells the home as a single individual, she would be eligible to exclude $250,000 of gains on her primary residence but would still be responsible for taxes on $125,000 of capital gains. On the investment account, the adjusted cost basis would be $750,000. So, there would still be $250,000 of unrealized gains that could be taxable.
Clearly, the above is a hypothetical example designed to highlight some of the differences in the application of the law. But the takeaway is simple: basis matters.
Gift vs Inheritance
Many times when talking with clients, we hear about assets that were “inherited” from a parent, grandparent, great-aunt… you get the idea. But were they actually inherited or received as a gift?
The manner in which the asset comes into your possession is important for tax purposes.
Did it come to you directly from your parents? Or perhaps it came from a trust that your grandmother set up 20 years ago, and now the assets are being transferred to your name. The fact pattern of “ownership” is critical to understanding what the cost basis of the asset is.
If you aren’t exactly sure, then there’s no time like the present to investigate precisely how you came to own the rights to that oil well in North Dakota (which, for those keeping track at home, is NOT a community property state!).
Conclusion
Understanding cost basis and its implications can help you make smarter financial decisions and potentially save on taxes. Remember, it’s all about that basis!🎵
Sincerely,
Craig Smith, CFP®, CFA®, CKA®
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.
