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BOB MADE A very expensive tax mistake. Doctors told Bob that he only has a year to live… What did Bob do?
He decided to gift a house to his only son before passing away. The house is worth $2,000,000 that he bought back in 1970 for $50,000 in an expensive suburb of California.
The son decided to sell the house and paid about $430,000 in federal taxes.
$430,000 that could have been $0 instead…
How?
When you gift a property to someone, they receive a “carryover basis.” It basically means the same price the original owner purchased it for.
The basis of that house was $50,000, so the son had to pay capital gains tax on the difference between the $2 million sale price and the basis, at rates reaching up to 23.8% on the top portion of the gain. But this is where a step-up in basis could come into play.
Assets such as a house or shares held in a brokerage account, when owned inside an estate rather than an irrevocable trust, receive a step-up in basis to their fair market value (FMV) at the time of the decedent’s death, per IRC Section 1014. In our case, if Bob held that house in his own name, passed away, and his son received the house, he would’ve gotten a step-up in basis to the current value, or $2M.
At the time of the sale, if sold for $2M, he would pay $0 in federal taxes, though state tax might still apply. That’s about $430,000 of “savings.”
“But who cares, Bob is dead anyways?”
While true, many parents still want to make sure their children don’t have to pay half a million in taxes. They want their children to enjoy the fruits of their hard labor.
Specifics
The step-up in basis can be a bit nuanced, depending on how the assets are held and titled.
First, the step-up in basis typically adjusts to the market value, unless an election is made to use the value six months after the date of death, subject to certain rules.
The step-up in basis also doesn’t apply to assets held in an irrevocable trust , though we will cover some strategies for that later, or to assets held in qualified retirement accounts, such as IRAs and 401(k)s.
In a community property state (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin), the basis steps up whenever a spouse dies. You will typically need to complete a form to receive this step-up in a brokerage account.
For assets held in joint tenancy, the step-up applies only to the deceased partner’s share. For example, Bob and Jenice have a house worth $300,000 with a $50,000 basis. After Bob passes away, Jenice will have a $175,000 basis in the house, calculated as ($300,000 minus $50,000) divided by two, plus $50,000.
There are also two additional things to keep in mind:
1. Living on the right assets
Bob, age 75, has two accounts: a traditional 401(k) worth $500,000 and a brokerage account worth $500,000. Bob’s diagnosis isn’t good.
From a tax-planning perspective, it might make a lot more sense to withdraw, say, $50,000 a year from the 401(k) to live on, $20,000 of which would be required minimum distributions (RMDs), and pass down the brokerage account to his beneficiaries.
This is because the brokerage account likely has a lot of gains. Bob bought many stocks in his 30s and 40s that could be stepped up now. But a more in-depth analysis might be needed if Bob has a lot of income and is in a high marginal tax bracket.
2. Selling the right lots
Say Bob has a $500,000 brokerage account. Some of the stock purchases have a low basis, meaning a lot of capital gains, and some have a high basis, meaning fewer capital gains.
It’s best to sell the high-basis stocks, which come with a lower capital gains tax, and pass down the low-basis stocks to the beneficiaries.
Planning matters. These mistakes can cost thousands of dollars in unnecessary taxes. As always, make sure to consult a licensed CPA or estate attorney with your unique circumstances.
Bogdan Sheremeta is a licensed CPA based in Illinois with experience at Deloitte and a Fortune 200 multinational. 
Thanks Bogdan for another important article. It seems no matter how well I think I know the rule, it always has nuances. You for sure have helped many understand how to keep taxes to a minimum. Nice work.
Community Property is a very important concept in the states where it is the law. Unfortunately, to gain the benefits a home must show this in the recorded title. And, in some states there may be nuances. Our home in WA shows our names and Community Property. Our AZ home shows our names and then Community Property Right of Survivorship. Generally, this is the kind of thing that your lawyer will examine when you update your wills etc.
Bogdan, thanks for a great article. I’m aware of a few cases where complex family dynamics lead to what would seem to be bad decisions. I have a friend and colleague who grew up on her family’s farm in western Pennsylvania. She had 5 siblings. All but one sibling left the farm and pursued successful careers. She and her siblings found out after the fact, that the sibling who remained on the farm had convinced the aging parents to gift the majority of the land to him and wife, effectively disinheriting my friend and the other siblings. The parents may have felt that their action was justified because the son who remained was taking care of them and the farm and deserved it. The siblings who left didn’t quite see it that way.
I also have a friend who, in her 80s, gifted her 2 sons her highly appreciated beach house, despite advice to the contrary. She passed away a few years later. The sons don’t appear to be planning to sell anytime soon, but I’m still not sure why she made the gift. There were some interesting family dynamics that may have caused the sons to fear their mother would disinherit them, and they pressured her to gift the home before she passed to prevent that.
Rick, these experiences illustrate why an attorney once told me that the probate process is like divorce court for siblings.
Great information, Bogdan. Tax planning is so important, and often complicated. Decisions made in ignorance can be costly. And, unlike the stock and bond markets, it’s one area of personal finance where we have control.