If you want to sell an asset, particularly a valuable asset, no one should do so without first understanding what the tax consequences might be. Understanding the tax consequence of a sale starts with understanding basis.
Understanding the Basis of an Asset – The Starting Point
An asset’s basis is often referred to as the amount an asset costs when you buy it. For example, if you buy stock for $20, the basis is $20. If you buy a house for $500,000, the basis is $500,000.
However, the original cost of an asset is only the starting point for determining basis. The basis in an asset can change for a variety of reasons. The most common reasons that the basis in an asset can change are:
- You add money to the asset. For example, if you make a capital improvement to your home, that increases your basis in the home.
- The asset splits. Let’s say that the stock that you bought split, you would have to split the basis in the stock in the same way that the stock split.
- You make certain tax elections. If you have a rental property or some other type of depreciable asset, you can depreciate the asset. Every time you depreciate the asset, the basis is reduced.
- The owner of the asset dies. When a person dies, the assets owned by that person receive a new basis equal to their value on the owner’s date of death. (This is often known as the step-up in basis rule. Technically though, it could be a step down in basis if the value on date of death is lower than the basis before death. Also note that technically you can value the assets 6 months after date of death if it reduces the federal estate tax.)
What Happens When You Gift an Asset?
There is a very big difference between gifting someone an asset versus leaving it to them on death. If you gift a person an asset, the basis carries over to the Donee. When you leave an asset to someone on death, it usually receives a step-up in basis.
Accordingly, when deciding whether to give someone a gift, it is smart to figure out the basis of what you are gifting away first. We generally do not recommend making a gift of any asset that has appreciated significantly since you purchased it. We also do not recommend making a gift of any asset that you have depreciated. It is usually better to leave people these types of assets on your death.
Note: Making a gift to a trust is an incredibly complex topic and I will try to address that in a future blog post.
Knowing an Asset’s Basis is Critical when Selling the Asset
It is critical to know an asset’s basis when selling it because there will be a tax on the gain. You can calculate the gain by subtracting the sales price (and related costs of selling) from the basis of the asset.
For example, if you buy stock at $20 and sell it at $100, the basis of the stock is $20 and the gain on the sale is $80. If you hold the stock for an appropriate time amount, the gain would be considered capital gain and taxed at the capital gains tax rate.
So, let’s assume that you buy a rental property for $200,000. You spend $100,000 improving it, depreciate it by $80,000, and then ultimately sell it for $750,000. The basis in the property would be $220,000 ($200,000 + $100,000 – $80,000). The gain would be $530,000. The IRS would tax $80,000 of that gain as ordinary income and the rest as capital gain. The tax rates would be affected by the overall amount of income that you earn.
If, on the other hand, you keep the stock and real estate in your name (or a revocable trust) until your death, your heirs would receive it with a stepped up basis. If your loved ones then sold it (without any other change in value), they would pay tax on the sale. (Note: Your death may trigger an estate tax or inheritance tax though.)
Common Complex Situations
Let’s complicate matters. Let’s assume Dad and Mom own a property that they bought for $150,000. They never made any capital improvements to the property. Dad dies when the value of the property is $400,000, leaving it to Mom. Determining the basis of the property as owned by Mom can be tricky. At the time of the purchase, Dad and Mom EACH had a $75,000 basis in the property. When Dad died, his interest received a new stepped-up basis of $200,000. Mom’s interest is determined by adding $75,000 (her own basis) to the $200,000 basis that she inherited from Dad. Therefore, her new basis would be $275,000.
This calculation is critical to know because often when one spouse dies, the surviving spouse will want to sell the primary home. When selling a primary home, a couple is entitled to a capital gains tax exemption of $500,000, but an individual is only entitled to a $250,000 exemption.
One of the big problems that people have is keeping proper records of the purchase price of their assets. Sometimes, assets can be passed down for generations before they are sold. If the owner cannot provide proof of an asset’s basis, the government will assume it is Zero. This could potentially cause a very large tax. (Accordingly, when someone says you can shred paperwork after 7 years, DON’T SHRED ANY PAPERWORK RELATING TO THE BASIS OF AN ASSET THAT YOU OWN!)
The tax that most often affects the sale of a valuable asset (in a non-business setting), is the capital gains tax. To understand this capital gains tax consequence, you must first understand and appreciate the incredible importance of “Basis”. Accordingly, before selling or gifting away any valuable assets, we highly recommend speaking with a tax attorney or an accountant first.