When considering different estate planning strategies and which direction to take, it’s important to consider the impact on basis. “Basis” is the benchmark used for income taxation.
What does income tax basis have to do with estate planning? Lots! Property included in your taxable estate at your death gets a “step-up” in basis to its value at your death. (Certain property like IRAs don’t get this step-up.) This article will lay the groundwork on basis. What is it? When is it adjusted? Etc.
Let’s say you purchase an asset. The amount you pay for the asset is your basis in the asset. That cost basis may be adjusted by real estate commissions or other expenses in the acquisition process. Let’s take an example. Bob negotiates to buy an apartment building for $1 million. He spends $100,000 on legal fees, surveys, title insurance, and commissions in the purchase of the building. His basis in the building is $1.1 million.
Let’s assume ¾ of the value of the purchase is the building and ¼ is the land. That means that Bob’s starting basis in the building is $825,000. Bob spends $137,500 on a new roof and other capital improvements, increasing the basis in the building to $962,500 and in the whole property to $1,237,500.
Over the course of time, Bob takes depreciation deductions. These deductions reduce his basis in the building. Bob’s starting basis in the building was $825,000, to which he added $137,500, for a total of $962,500. Bob’s depreciation is $35,000 per year because the building is depreciated over 27.5 years. So, each year the building is in service, Bob’s basis will decrease by $35,000, assuming he makes no other improvements or other adjustments to basis. After ten years, Bob’s basis is decreased by $350,000 due to the depreciation. So, his basis in the property in ten years will be $1,237,500 less $350,000, or $887,500.
If Bob sells the property, he’ll recognize gain to the extent the purchase price is over his basis of $887,500. Any gain will be taxed as ordinary income to the extent of the depreciation he took of $350,000. This is the downside of depreciation.
It’s great when you’re taking the income tax deductions, but it’s painful to have your basis lowered and the gain recaptured as ordinary income. Let’s assume the value of the property after ten years is $2 million. Bob would recognize gain of $1,112,500, of which $350,000 would be recaptured as ordinary income and the remainder would be long-term capital gain.
Let’s assume Bob would pay a combined state and federal income tax of 40% on ordinary income and 25% on capital gain income. That means Bob would pay tax of $140,000 on the $350,000 ordinary income portion and $190,625 on the $762,500 taxed at long-term capital gain rates. Thus, Bob’s total income tax if he sold the property would be $330,625, leaving $1,669,375 after income tax.
Before he can sell the property, Bob dies and leaves everything to his daughter, Emily. Emily receives the property with a basis of $2 million, its value at the date of Bob’s death. The depreciation Bob took is wiped away. If Emily wishes to sell the property for $2 million, she’d pay no income tax. If she wishes to continue holding it, she’d get to start depreciating from a new, higher baseline.
This article examined the income tax consequences of keeping the property until death. Upcoming articles will examine other strategies and their impact on income tax basis. Income tax basis is an important consideration when choosing a direction for your estate plan.
Stephen C. Hartnett, J.D., LL.M.
Director of Education
American Academy of Estate Planning Attorneys, Inc.
9444 Balboa Avenue, Suite 300
San Diego, California 92123
Phone: (858) 453-2128
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