Property owners will have decisions to make when it comes to estate planning, and one of those has traditionally been whether to give property to heirs before or after death to reduce “death taxes.”
But Montana State University Extension educators say that — thanks to Montana eliminating the state inheritance tax in 2001 and federal estate tax only impacting individuals with estates valued at more than $11.58 million and married couples with above $23.16 million — it is more important nowadays to consider the income tax consequences of the timing of gifts to heirs.
“When you sell property, not all of the proceeds are taxable,” said Marsha Goetting, MSU Extension family economics specialist.
Goetting said that when you calculate income, a person is only taxed on the difference between their “basis” in the property and its sale price. As a general rule, “basis” is the amount paid to buy an asset, like a house, car, equipment or stocks. The basis of some assets, such as equipment in a business, can depreciate. So when an asset is sold, the tax liability is calculated based on the sale price received minus the depreciated basis, she said.
In deciding whether to make a gift before death or in a will, an individual should understand the difference between a “stepped-up” basis and a “carry-over” basis, Goetting said.
For example, a widow is trying to decide if she should gift her home to her daughter or leave it to her after death. She and her late husband bought the home 40 years ago for $45,000 and it is now valued at $250,000. While there are personal considerations for one choice over the other, understanding the difference between a stepped-up and carry-over basis may influence decisions, said Goetting.
If the widow leaves her home to her daughter in her will, the home’s basis “steps-up” from the $45,000 she paid to buy it to the value upon her death: $250,000.
“This eliminates the daughter’s income tax liability on appreciation in the property’s value occurring during the mother’s lifetime,” said Wendy Wedum, MSU Extension Pondera County agent.
“In other words, if the daughter sells the house immediately after her mother’s death for $250,000, there is no income tax liability,” Wedum added. “If she sells the house two years later for $260,000, the daughter would only pay tax on the $10,000 increase in value after her mother’s death.”
Property transferred as a gift before death has a carry-over basis, meaning the original cost basis of the house, less any depreciation, carries over to the daughter. Because the home was not used in a business, the widow’s original basis of $45,000 was not depreciated and the daughter’s basis in the house is $45,000. If the daughter sells the house for $250,000, she will pay a capital gains tax on the appreciation, or increase, of $205,000 in the property’s value during her mother’s lifetime. If the daughter is in the highest income tax bracket, she could pay combined federal and state income taxes in excess of $40,000.
Goetting and Wedum suggest that if estate value falls under the current $11.58 million limit and a parent wants to make a substantial gift to their children, choosing a stepped-up basis with a gift at death lowers the impact of income taxes and the beneficiary receives the most value from the asset.
“People have worked hard for their property and should look at all the possibilities before making a final decision on whether to make a gift before death or at the time of death and take advantage of the current tax rules,” Goetting said. “If you are contemplating a significant gift, consult your accountant or attorney for an analysis of the tax or other legal consequences you should consider.”