Why these taxes have become more important to estate planning

With the U.S. estate-tax exemption now sitting at $5.43 million per individual — $10.86 million for married couples — some affluent families are turning their attention to another kind of tax: capital gains. Only two in every 1,000 estates now pays the federal estate tax since Congress raised the individual exemption amount significantly in the American Taxpayer Relief Act of 2012 (ATRA), according to recent estimates from the Joint Committee on Taxation¹. Conversely, the top capital gains tax rate increased from 15% to 20% under ATRA and now applies to more taxpayers.

Reducing the Impact

To minimize their capital gains tax obligations, some families are taking advantage of “step-up” basis rules that allow them to adjust the cost basis of appreciated assets when they pass along those assets as an inheritance. The rules effectively allow heirs to avoid paying capital gains taxes on the appreciation of assets that occurred before they inherited them.

In practice, the rules encourage taxpayers to hold on to real estate, stock and other appreciated assets until their death rather than selling those assets during their lifetime, says Terisa Heine, a Trust Advisor for Regions Private Wealth Management in South Florida. “For those assets that have increased in value significantly, it can make sense to hold them until death, so you receive that step-up,” she says.

Here’s how step-up rules work: Assume that years ago you purchased 1,000 shares of stock at $1 a share. The value of each share has since jumped to $100, making the investment now worth $100,000. If you sell the stock while you’re alive, you would pay capital gains tax on $99,000 — the $100,000 sales price minus your $1,000 investment. At a 20% capital gains tax rate, the tax bill would come to almost $20,000.

However, if you keep the shares and bequeath them in your will, your heirs’ cost basis would “step up” to the fair market value at the date of death. So if they inherit the stock at $100 per share and later sell it at $105 per share, the capital gains tax would apply to only the $5 per share of appreciation.

The Specifics

Step-up rules can be used with various assets, including stocks, bonds, real estate and businesses. They typically don’t apply to assets held in retirement accounts, such as 401(k) plans or IRAs, Heine says. Moreover, assets placed in trusts don’t automatically qualify for step-up rules, but individuals can work with a trust advisor to structure a trust in a way that allows them to qualify, she adds.

The application of step-up rules can also vary by state. In states with community property laws that require all marital assets be divided equally between spouses, when one spouse passes away, the other spouse’s cost basis of any assets is often the fair market value on the date of the deceased spouse’s death. So, in that scenario, if a couple purchased a home for $100,000 that’s now worth $1 million, the surviving spouse’s basis would be $1 million.

In states without community property laws, generally just the decedent’s portion of the assets is stepped up. In the above example, the cost basis of the deceased spouse’s portion of the home would be stepped up to $500,000, while the basis on the other half would remain at $50,000, or half the $100,000 initial cost, for a total basis of $550,000. If the surviving spouse sold the house, he or she would pay capital gains on $450,000, or $1 million minus $550,000.

Some states impose their own estate taxes, which can also impact the decision of whether to try to minimize estate taxes or capital gains taxes. In states with relatively low exemption levels, it often makes sense to place more effort on reducing the size of one’s estate than on lowering capital gains. “In these states, more traditional trust planning may be needed to avoid losing the state estate-tax exemption,” Heine says. Similarly, taxpayers whose estates will exceed the federal exemption level will want to weigh the benefits of reducing the sizes of their estates, versus the advantages of holding on to assets until their death and leveraging the step-up rules to cut the capital gains tax.

Step-up rules can come into play in another way as well: Some individuals use the assets they own as collateral for loans when they need income. That way, they can avoid selling the assets and generating capital gains tax. “You want to protect those assets and not have to liquidate them,” Heine says. Of course, the decision to do this should factor in the need to repay the loan.

Planning for estate and capital gains taxes remains a complex endeavor. Your Regions Wealth Advisor can connect you with specialists at Regions to help you formulate tax strategies that work for you.

¹Joint Committee on Taxation, “History, Present Law, and Analysis of the Federal Wealth Transfer Tax System,” March 16, 2015.