When you sit down to create your estate plan you will likely be attempting to achieve a variety of goals all at the same time. Your primary goal will undoubtedly be creating a roadmap for the distribution of your estate assets when you die; however, you may also be concerned with things such as probate avoidance, incapacity planning, and decreasing your estate’s exposure to taxes. One issue that will not impact you, or your estate, directly but which may impact your beneficiaries is capital gains taxes.
Capital gains taxes are paid at the federal level whenever you realize a gain upon the sale of a “capital” asset. Though there are other examples, real property is the most commonly sold capital asset. To illustrate how capital gains taxes are calculated, imagine that you purchased a property in 1995 and paid $100,000 for the property at that time. Let’s assume that you sell the property today for $175,000. You have realized a gain of $75,000. That gain is then potentially subject to the payment of capital gains taxes. So what does this have to do with your estate plan? If you have capital assets in your estate that need to be passed down you should take capital gains taxes into account when deciding how and when to pass down those assets.
When calculating capital gains tax you must first figure out what the “basis” of the asset is. For real property, the basis is usually the purchase price plus any improvements made to the property. If you gift that property, the recipient may be required to use your adjusted basis or may be able to use the fair market value, or FMV, at the time the gift was made. If the property is inherited, the recipient is allowed to use the fair market value on the date of death. The difference can be significant.
Imagine that you gifted the property discussed earlier to a niece prior to your death. If your niece then decided to sell the property five years down the road for $200,000 and she was required to use your basis in the property she has realized a gain of $100,000 which is subject to capital gains taxes. On the other hand, if you gift her the property in your Last Will and Testament and she is allowed to use the FMV when she sells the property in five years she has only realized a gain of $25,000 on which capital gains are due.
Before you make decisions regarding the disposition of valuable estate assets be sure you consult with both your estate planning attorney and your financial advisor.