Guest Blog: Maximize Wealth for Your Beneficiaries — Understanding Capital Gains

Building wealth is critical, not just for your personal peace of mind as you get older, but also to have something to pass onto your beneficiaries to make their lives a little easier. Unfortunately, people sometimes become so focused on building their wealth that they fail to guard against the eroding effects of taxes.

Luckily, with some good advice and proper planning, you can minimize or even eliminate taxes when you transfer your wealth to future generations. Paying fewer taxes means more money in the bank, where it belongs.

One of the most common tax issues that arises when individuals transfer their wealth is the capital gains tax. Here are some quick tips on how to navigate it.

Capital Gains Tax

Let's start with a simple primer on capital gain income. When you purchase an asset, your tax “basis” in that asset is essentially the price you paid for it. With any luck, that asset will appreciate in value over time. Although the asset’s value may appreciate significantly, your tax basis generally remains fixed and does not change over time. If you later sell that asset, your capital gain income from the sale is calculated by subtracting your tax basis from the sale price. Your capital gain income from the sale is then taxed. The more capital gain income that you earn on the sale of an asset, the more capital gains tax you will have to pay.

An example using numbers may be helpful here. Let’s say Jane Doe purchased 1,000 shares of stock in XYZ Corporation for $100,000 in 2005. Jane’s tax basis in the stock is $100,000. By 2015, her 1,000 shares of stock have appreciated to $250,000. Jane has decided to sell her stock and give the money to her son, John. If Jane sells all of her stock for $250,000, we calculate her capital gain income by subtracting her basis [$100,000] from the sale price [$250,000]. Consequently, her capital gain income from the sale of the stock will be $150,000. She will have to pay a capital gains tax on her $150,000 in capital gain income. The money she had hoped to give to John must first be reduced by the capital gains taxes that are owed.

Fortunately, there is a big capital gains tax benefit that is triggered upon your death. When you die, the assets that you own will ordinarily enjoy a “step-up” in basis. (This is spelled out in the Internal Revenue Code §1014(a).) The step-up means that your basis in the asset resets to the full value of the asset on the date of your death. Consequently, when your beneficiary inherits that asset, the beneficiary’s tax basis in that asset will become equal to the asset’s value on the date that you died.

To illustrate this, let’s go back to our example with Jane. Her 1,000 shares of stock in XYZ Corporation are worth $250,000 in 2015. Jane dies in 2015 and John inherits all of her stock shares. Jane’s death means that John’s tax basis in the stock will be “stepped-up” to $250,000, which was the value of the stock when Jane died. If John then immediately sells the stock for $250,000, John’s capital gain income will be zero — there is no capital gain when we subtract John’s “stepped-up” tax basis [$250,000] from the sale price [$250,000]. If John has no capital gain income, John will not owe any capital gains tax.  John will get to keep the full $250,000 from the sale.

As you can see, the step-up in basis provides a significant mechanism to reduce or eliminate the amount of capital gains tax your beneficiaries may owe on the assets they inherit from you. As you are putting your estate plan together, please consult with a qualified professional to see how you can make the “step-up” work best for you.

About the Author
Angela Kil

Angela Kil is an Associate at Carico Johnson Toomey LLP. You may remember Angela from UWM's Longevity Planning Forum Series. Her practice focuses on Trust and Estate litigation, Estate Planning, Trust and Conservatorship administration. She has represented individuals and fiduciaries at every stage of estate management and has counseled fiduciaries and beneficiaries in a variety of property disputes, probate and trust accounting disputes, will and trust contests, conservatorships, and financial elder abuse. Angela holds a BS in Biochemistry and an MS in Microbiology, Immunology, and Molecular Genetics from UCLA. She received her JD from Loyola Law School in Los Angeles and served as a law clerk for Judge Richard L. Fruin of the Los Angeles Superior Court.