Minimizing tax liability is one of the most important aspects of estate planning. For those who possess significant assets, Capital Gains Tax can seriously eat into the value you want to pass on to your children. As with all things related to the Law and Taxes, there are exceptions and exceptions to those exceptions. In this blog post we will explore a little-known exception to the step-up in basis rule and how this little known tax code provision can trap the unwary.
Capital Gains Tax is a tax burden imposed on the increased value of an asset held over time. The most common examples of this are real estate and securities, like stocks or bonds. Indeed, investing in the stock market is primarily the practice of accumulating capital gains. You purchase a share of a company you believe will be successful in the future with the hopes that the value of that share will increase as the company grows. Eventually, if you have invested carefully, you will be able to sell your share for more than you initially paid for it. That differential in purchase price and sale price is your capital gain. Like most other forms of income, it is subject to taxes.
It can be said that the Government gives citizens two gifts upon their death: the federal estate tax exemption and an adjusted cost basis or a “step-up” in cost. The federal estate tax is a tax placed upon the total value that is transferred from a decedent to their heirs. It has a long history of heated debate between those who believe it’s necessary to prevent the ultra-wealthy from accumulating too much wealth, and those who believe it’s wrong for the government to interfere with the right to pass belongings to your children. As a compromise between these two positions, the estate tax exemption was born. This exemption carves out a threshold below which the estate tax does not apply. This threshold is significantly higher than most people will ever generally accumulate during their lifetime, so it prevents lower- and middle-class people from losing any of their estate to taxes upon death. But above the threshold, which in 2022 sits at $12.06 million dollars, estates will pay anywhere between 18% and 40%, depending on the total taxable amount.
The other ‘gift’ upon death is a step-up in basis on assets like securities and real estate. One’s cost basis in a given asset is the price you paid for it. That figure is important because Capital Gains Tax is based on the increase in value between what you paid for an asset and what you sold it for. In other words, Capital Gains Tax is based on the difference between your cost basis and what you sell the asset for. When a person dies, the government allows a basis readjustment on the asset owned at death, to the then current fair market value. If this asset is immediately sold, this effectively exempts those assets from Capital Gains Tax because the difference between the basis and the sale price becomes zero. This is effectively a gift from the government to the heirs of a decedent, who, depending on how long the decedent owned the asset, and how much it has appreciated, are exposed to a significantly lower tax liability. For an illustration of this rule, imagine you bought one share of Orange, a company that builds computers and cellphones, for $100 in 1980. Today, Orange shares are now worth $20,000. If there was no step-up in basis, upon your death, if the asset was sold, the recipient would pay capital gains tax on the difference between your basis, $100, and what the share is sold for, $20,000, meaning they would have to pay taxes on that $19,900 profit. With the step-up in basis rule in place, the recipient of the asset would have to pay little to no capital gains tax because the IRS would consider your basis in Orange stock to be the fair market value on the date of your death, which would be $20,000. For people who have significant appreciated investments, the step-up in basis can save their heirs vast sums of Capital Gain Tax exposure.
So, the estate tax exemption is an exception to estate tax, and the step up in basis is an exception to Capital Gains Tax; would you be surprised to learn there is yet another exception? U.S. Tax Code subsection 1014(e) is a little known, rarely cited provision of the step-up in basis rule that prevents people from claiming the step-up in basis under certain conditions. The text of 1014(e) is as follows:
In the case of a decedent dying after December 31, 1981, if—
(A) appreciated property was acquired by the decedent by gift during the 1-year period ending on the date of the decedent’s death, and
(B) such property is acquired from the decedent by (or passes from the decedent to) the donor of such property (or the spouse of such donor),
the basis of such property in the hands of such donor (or spouse) shall be the adjusted basis of such property in the hands of the decedent immediately before the death of the decedent.
The text of this provision is fairly confusing upon the first read. It will be helpful to define a few terms: appreciated property means any property that has increased in value while you have owned it. Adjusted basis is the original price you paid for the asset, plus or minus certain minor adjustments, effectively the opposite of a stepped-up basis. In plain language, 1014(e) states that if the property in question was acquired within 1 year of the date of death of the decedent, and the property is being passed back to the donor of the property or their spouse, they will not receive a step-up in basis. For example, a son gives his father Orange stock that he purchased 20 years ago, knowing he is his father’s sole heir. Six months later, the father passes away. Without 1014(e), the son’s new cost basis in the asset would be adjusted to its current market value. In effect, the Son would eliminate his own Capital Gains tax liability by giving the asset to his dying father. The purpose of this provision is that Congress wanted to avoid people making death-bed transfers of valuable assets to be given right back to the donor simply for the purpose of avoiding Capital Gains tax. Congress was happy to provide this generous benefit to those who had acquired and held assets in the normal course of life but did not want individuals on their death bed to become clearing houses for savvy investors. When making gifts to terminally ill individuals, it would be wise to keep Section 1014(e) in mind. If the recipient passes within a year of the gift it may not qualify for a step-up in basis.
Interestingly (perhaps only to lawyers) Section 1014(e) has never once been mentioned or adjudicated in any court of law. Considering the sheer volume of Tax Court cases filed every year, and the huge potential for gain/loss that this provision presents, it is quite surprising that no court has ever been asked to review it. Because of this, there is basically no official guidance on how to apply this section, or how to resolve some of its inherent ambiguities.
The content of this blog is intended to be general and informational in nature. It is advertising material and is not intended to be, nor is it, legal advice to or for any particular person, case, or circumstance. Each situation is different, and you should consult an attorney if you have any questions about your situation.