Ethan R. Okura
Hawai‘i Herald Columnist
To plan your estate properly, it is important to understand “stepped-up basis.” When you buy property (for example, real estate or stocks) your tax basis in the property is the amount you pay for the property. When you sell the property, you have profit or gain equal to the difference between the sale price and tax basis (sale price – tax basis = gain). You have to pay capital gains taxes on your gain.
For example, suppose you bought a vacant lot on O‘ahu many years ago for $150,000. Now, that same vacant land is worth $850,000. If you sell that land for $850,000, your gain is $700,000 ($850,000 – $150,000 = $700,000). You have to pay capital gains taxes on that gain. The federal capital gains tax rate for property held more than one year is generally 15% for low-income earners, but it will be 20% if your income is high for the year. Because your income for the year would also include the capital gain from the sale of property as part of your income, the capital gain tax rate of 20% would apply. The state of Hawai‘i rate is 7.25%. You would have to pay $190,750 in taxes. (If you itemize deductions, you can take a deduction the following year on your federal income tax return for the state taxes paid.)
Instead of selling that land, suppose you give it to your son. Your son’s tax basis in the land is $150,000. When he sells that land for $850,000, he will have to pay the capital gains tax of $190,750.
Now, here is the estate planning opportunity. Suppose after you bought that land for $150,000, you did not sell or give it to your son. Instead, you hold on to the land until you die. Your son inherits the land from you. Then he sells it for $850,000. He does not have to pay any capital gains taxes at all! When you die, while still owning that land, the tax basis in that land changes or “steps up” from $150,000 to $850,000 (the fair market value on the date of death). It is as if your son bought the property from you for $850,000. When he sells it for $850,000, his gain is zero ($850,000 sale price minus $850,000 tax basis equals zero). Therefore, his tax is zero. Your son saves $190,750 in taxes by inheriting property from you instead of getting it from you while you are still alive.
The same rule applies to your home. Often, a father or mother doesn’t want problems for their children, so the parents give their home to the children while they are still living. Sometimes the children kick their own parents out of the home! Even if your children and their spouses don’t kick you out of your home, you may be giving them a future capital gains tax problem when you just put the property in their name, because they will not get a “stepped-up basis” when you die.
This stepped-up basis rule also applies to stocks and rental property. With rental property, the tax basis goes down every year as you depreciate the property. Stepped-up basis does not apply to annuities or IRAs. Here is another exception: If you give property to someone, and that person dies within one year, and you or your spouse inherits that same property from that person, then you do not get a stepped-up basis.
One of the best ways to get a stepped-up basis for your home is to give it to your children, but continue to use and enjoy the property without paying rent for your lifetime — or better yet, give it to an irrevocable trust for the benefit of your children, but keep the right to change who will inherit the property from the trust when you die. You have given the home away, and protected it from nursing home costs, but you have the right to live there for the rest of your life, or change who will inherit it when you die. Because you kept the right to live there, or the right to change who will inherit it, the property gets a stepped-up basis when you do pass away. Your children could then sell it for the date of death value without paying any capital gains taxes.
In 2021, a person can die with up to $5.49 million in Hawai‘i without paying any death taxes. For many people, death taxes are no longer a problem. We need to be paying more attention to capital gains taxes, which our children or other loved ones may have to pay if they sell property we give to them. Giving away property is not as simple as most people think. Before you give away any real estate or stocks that have gone up or down in value, check with an estate planning specialist as to how the tax basis rules will affect your gift.
Ethan R. Okura received his JD from Columbia University in 2002. He specializes in Estate Planning to protect assets from nursing-home costs, probate, estate taxes and creditors.
This column is for general information only and is not tax or legal advice. The facts of your case may change the advice given. Do not rely on the information in this column without consulting an estate-planning specialist.
© OKURA & ASSOCIATES, 2021
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