Last week, I committed a terrible tax blogging sin: I used jargon. I try not to use jargon on my blog. I find it annoying, for one, because who wants to actually sound like a tax attorney (no offense to my esteemed colleagues). But more importantly, what’s the point of reading a blog that you can’t understand?
So, I’m making amends with a quick explanatory post about basis. Here’s the context: there’s a current proposal in Congress to reinstate the federal estate tax with a higher personal exemption and a “stepped up” basis for assets. The proposal also includes an election for 2010 to be taxed at the 2011 rate with “stepped up” basis rather than at a zero rate with “carry over” basis. So what the heck does any of that mean?
Basis is, at its most simple, the cost that you pay for assets. The actual cost is sometimes referred to as “cost basis” because you can make adjustments to basis over time.
So, for example, if you buy a house for $150,000, that’s your cost basis. Say you make a capital improvement to your home – not painting your bedroom or changing the drapes. I’m talking a major change that adds permanent value to your home. You add a second story or you attach a garage. That changes your basis. If that change cost you $15,000, then your basis is $150,000 (original purchase price) + $15,000 (adjustment to basis) = $165,000.
Stocks and similar investments work the same way. Usually the basis of homes, stocks and other personally-held capital assets can be figured out without too much drama. There are, however, complicated maneuverings that go on with certain kinds of property like commercial assets and partnerships – it’s best to have a good tax professional for those.
To figure out a gain or a loss for income tax purposes, you take the price of the asset at disposition (in most cases, the sale price) and subtract the adjusted basis. That difference is your gain or loss. So in my home example, if I sold the home for $200,000, the gain is $35,000 ($200,000 less $165,000).
Traditionally, when a person dies, the gain on the property isn’t actually realized for income tax purposes at death. That’s because the law allows a “step up” in basis for assets held at death. The basis is increased to the value of the asset on the date of death. So in my example, if the home was worth $200,000 on the date of death, the new basis is $200,000: forget about the purchase price and the adjustments. When the estate (or heir) sells the property, the gain is the selling price less $200,000. Assuming that the sale happens close to the date of death, there is generally no gain – or very little gain – for income tax purposes.
In contrast, “carry over” basis means that the original basis of the asset carries over from one owner to the next. You hear about this most commonly in the context of making a gift. So in my home example, if the home is given away during lifetime, even if the home was worth $200,000 when the gift is made, the basis for the new owner is $165,000 (the former owner’s basis). In a “no federal estate tax” world, this “carry over” basis also applies to property passing at death with a few notable exceptions (including a $1.3 million exemption and additional rules for property passing to a spouse). There’s no “step up” like before.
You can imagine the difficulty in trying to sort out the basis then, for an asset that had been owned for quite sometime (that banging you hear is the collective heads of tax attorneys smacking a table while staring, blurry-eyed at utility stocks held in certificate form). It’s quite the challenge. This is the kind of thing that Congress didn’t spread around on the front pages of the papers when touted their repeal. 2010 isn’t exactly the magic bullet for estates after all but that’s a whole other policy post for another day.
So, to recap:
- Basis = cost + adjustments.
- “Stepped up” basis = value of assets held by the decedent at death.
- “Carry over” basis = original basis of asset carries over from one owner to the next.
Did I redeem myself?