Many taxpayers think they can save taxes by giving property to a close relative before they die. If you’re thinking about doing this, you could be making a mistake that can cost your heirs a substantial amount of tax money.
Take Ben Williams, for example. For many years, Ben had been the favored painting contractor in his home town. Inside or outside, from doorsteps to double-deckers, Ben Williams got the call when homeowners wanted a first class paint job at a reasonable price.
Ben wielded a mighty paint brush, but his climb up the ladder of success was modest. as he gave a fresh new look to house after house, Ben wondered when he could touch up his financial affairs and buy a house he could call his own. The opportunity finally came in 1990 when Ben, negotiating from atop his painter’s scaffolding, paid $150,000 for a comfortable cottage he was painting. It was a proud moment for Ben and it proved to be a sound investment.
Now, if there’s one thing that house painters have, it’s plenty of time to think. and as Ben approached retire- ment, his thoughts turned to how he could save his family from an excessive tax burden and costly legal fees when he finally departed to meet The great painter In The Sky.
By the time he retired, Ben’s strategy was clear to him. His estate was modest – a little cash, some personal effects, and the house he had bought which had appreciated considerably in value. So Ben made a gift of his residence to his only son, george, and spent his re- maining days thinking he had painted a better tax picture for his family.
Ben Williams remained in the house until his death in 2012. Within a few months, george sold the property for $370,000 – its fair market value – for a gain of $220,000. But when george Williams filed his 2012 individual income tax return, he discovered that for tax purposes, the cost basis of property acquired by gift is that of the last preceding owner who did not acquire the property as a gift. Since the last preceding owner was george’s father, who had paid for the house with his own hard earned money, the cost basis for the property will be what Ben Williams paid for it – $150,000. Consequently, when george files his 2012 individual income tax return he will need to include the $220,000 gain from the sale of the house and pay a substantial tax on the gain – a hefty tax burden that Ben Williams thought he had avoided.
A BETTER SOLUTION
The income tax cost basis for property acquired from a decedent is generally the fair market value of the property on the date of the decedent’s death. This is called, “the stepped-up basis rule” and, if Ben Williams knew about it, he could have protected his family from paying any taxes on the gain from the sale of the property.
Under the stepped-up basis rule, the basis for property acquired by inheritance is increased from actual cost to the fair market value of the property at the time of the owners’ death. This shields beneficiaries from paying income taxes on the appreciation of the property prior to the death of the owner.
Therefore, if Ben Williams had retained ownership of his house, its estate value would have been its fair market value when Ben died. george’s stepped-up basis for tax purposes would then have been $370,000. Because george sold the property for its fair market value, he would have had to report no tax- able gain on his 2012 federal income tax return and his income taxes on the appreciation would have been reduced to zero. That’s a huge savings, which is enough to paint quite a few houses.
Ben Williams was a professional painter, but he should have brushed up on his knowledge of the tax law by consulting with a professional accountant before he gave his house to his son. Just as in painting, a little preparation can go a long way toward getting the best possible result.
