Over the past couple of decades, Congress has passed several laws impacting the Federal estate tax exemption, resulting in a significant increase from $675,000 in 2001 to $11.58 million today. As a result, under the current rules, most taxpayers will not be subject to a Federal estate tax liability, and thus, the current focus of tax planning for one’s estate should generally focus on reducing Federal income tax liability. Basis management is a critical part of this process and includes strategies to both maximize the step-up in basis, as well as to minimize the loss of any unrealized and/or carryforward capital losses.
For spouses, two questions are important in determining adjustments to the basis of inherited (non-IRD) assets: 1) who owns the asset, and 2) whether the state of residence is a community property or separate property state. In separate property states, property ownership is generally determined by common law, which generally dictates that property is owned as it is actually titled. Thus, if an asset is in an account that belongs solely to the deceased spouse, then 100% of the asset is subject to a step-up (or step-down) basis adjustment; however, for assets held jointly (typically either as joint tenants with rights of survivorship or tenants by the entirety), the surviving spouse will typically receive a step-up/step-down basis adjustment on only one-half of the assets (the half of assets considered to have been owned by the deceased spouse).
By contrast, in states that follow the “community property” rules (AZ, CA, ID, LA, NV, NM, TX, WA, and WI; with AK also allowing couples to opt-in to community property treatment), most assets acquired during marriage, as well as those assets which are mutually agreed upon to be jointly owned or that can’t clearly be identified as either spouse’s separate property, are essentially treated as being simultaneously owned 100% by each spouse. Accordingly, these assets will automatically receive a full step-up/step-down adjustment on the entire value of the property upon the death of either spouse.
This basis adjustment of inherited assets at death can potentially result in losing out on the opportunity to benefit from realized capital losses, which can be used to offset capital gains and up to $3,000 ordinary income each year. However, by gifting assets prior to death, the original owner’s basis can be retained, and unrealized capital losses preserved!
For non-spouse beneficiaries, the benefits of gifting assets with potential capital losses are not quite as favorable as those for spouse beneficiaries but remain valuable, nonetheless. More specifically, when a non-spouse receives an asset with unrealized capital losses, the so-called ‘double basis’ rules apply. These rules use the value of a gifted asset on the date of the gift to calculate the amount of any capital loss. On the other hand, the donor’s basis at the time of the gift is used to calculate the amount of any capital gain.
Application of the ‘double basis’ rules results in three potential consequences for non-spouses who are gifted with assets that have unrealized capital losses: 1) If the sale price of the asset is less than the fair market value on the date of the gift, then the recipient of the gift can claim a loss equal to the difference between those two values; 2) If the sale price of the asset is more than the original owner’s basis on the gift date, then the recipient of the gift has a capital gain equal to the difference between those two values; and 3) If the sale price of the gifted asset is in between the fair market value on the gift date and the original owner’s basis, the recipient has neither a capital gain nor a capital loss.
Ultimately, the key point is that gifting assets is a simple yet effective strategy to preserve the economic value of unrealized capital losses that can be used to reduce future capital gains (and up to $3,000 of ordinary income, annually). As while the basis of inherited assets will generally receive a step-up (or step-down, depending on the FMV) adjustment at death, unrealized capital losses from inherited assets are essentially useless after the original owner’s death since they will no longer be available for use to offset any gains in tax years after death.