The general rule is that upon the death of an individual the tax basis of assets owned by that individual gets an adjustment for income tax purposes to the date of death value.
This tax basis adjustment does not apply to certain assets like annuities, IRA accounts, installment sales or similar assets. This basis adjustment can be very helpful for assets that have appreciated in value. For example, let's say the stock you purchased in XYZ Corp. 25 years ago for $10 is now worth $100. If you had sold that stock before your death, the tax would be on capital-gain income of $90. If the stock were sold by your estate or descendants after your death for $100, there would zero tax because of the basis adjustment referenced above.
What happens, however, when the market has taken a significant downturn and you have many assets or one significant asset that has a current value much lower than its original purchase price? In this case, if the value was $100 when purchased and today is $10, there would be a significant step-down in value upon your death. In that circumstance, when the value grew over the years following your death back to $100, your beneficiaries would again have $90 of capital-gain income when they sold the asset.
Generally it is wise to avoid a step-down in basis by reason of death. Traditionally, pre-death planning advice for a terminally ill person includes the sale of assets that would generate a loss if it is likely that the loss could be used to save income tax. In some instances the sale of the assets at a loss is not practical or could not be used by the decedent in his or her final income tax return.
Is there a way that the high basis can be preserved after death? Yes. Two methods of preserving the benefit of the high basis for the family are a gift of the high basis asset and a sale to related parties or trusts or other entities owned by or for the benefit of related parties.
Gift Before Death
When a person makes a gift of an asset with a tax basis higher than the value at the time of the gift, the recipient has two basis numbers that may impact future transactions with respect to that property. For determining a future loss on sale, the value of the asset on the date of the gift is used for the tax basis. For purposes of determining gain on a future sale, the original tax basis is used. This means, in our example above, that if the donor's basis was $100 at a time when the value was $10, the recipient of the gift would have a basis of $10 for purposes of determining any loss on a future sale and $100 for the purposes of determining any future gain. Basically, any sale by the gift recipient between the $10 value on the date of gift and the $100 basis would be tax free. Thus, the gift can preserve the benefit of the high basis for related family members.
Sale To Related Parties
Sometimes a gift is not practical either because it would generate significant gift tax or the donor needs the asset for future financial needs. In that case, the owner of the high basis/low value asset could sell the asset for current market value to related persons or an entity for related persons (such as a trust). Under the Internal Revenue Code, when a sale is made to a related person at a loss, the loss is not permitted to be recognized by the selling party. For future transactions by the purchasing party, the disallowed loss is added to the basis for determination of gain purposes. Thus, somewhat similar to a gift, the recipient purchasing the asset for $10 when its tax basis in the hands of the selling related shareholder was $100 would have an asset that could grow in value to $100 without incurring any capital gain tax on the sale of the asset. Note, in this instance the benefit of the disallowed loss is only to the original purchaser and not future purchasers.
While tax considerations may be the least of a family's worries when a loved one is on his or her deathbed, proper planning and action can result in significant tax savings for the survivors. A person should encourage his or her representatives and family members to consult with his or her attorney in the event of any terminal illness diagnosis. These and other important planning considerations may then be implemented for the long-term benefit of those that the person cares about.