As you may already know, there are two main methods for estate tax calculation - the "step-up" basis method and the "ordinary income" method.
The step -up basis method allows for the fair market value of an asset to be used as its final estate tax value upon death. This is often known as "inclusion" because the step-up in value is taxed, but at a much lower rate than if it were taxed as ordinary income.
Instead, there are certain cases where the executor of the estate is allowed to choose between these methods. If choosing the step-up basis doesn't provide you with a lower tax bill, then why would anyone choose it?
The answer lies in unrealized gains. When an asset has appreciated but not been sold, its value on the executor's books will be higher than the current market value. When this higher value is the final basis in the asset, there will be an increase in value when it is sold at market rate.
When the asset is sold, this gain will be taxed at 0 to 20% percent instead of your top marginal rate. This could potentially save you hundreds of thousands of dollars in taxes over just a few years. This can work with almost any asset that has appreciated without being sold, including real estate and art collections.
Current Capital Gain Tax Rates:
Capital Gains Rates on Assets Held Less Than One Year: Short Term Capital Gains are taxed the same as ordinary income rates.
Capital Gains Rates on Assets Held More Than One Year: Long Term Capital Gains are taxed at 0%, 15% or 20% depending on your taxable income and filing status.
Using the step-up basis method can be beneficial to those who will own the assets for a long time and/or at a high rate of return such as parents, grandparents, and family business owners. Additionally, because this additional tax savings is not available to corporations it only benefits individual taxpayers.
When someone is in the process of creating an estate plan, they may not realize how important it is to protect their assets.
What people don't seem to understand is that when they set up their will or any trusts they are also setting up the rules for what happens to their money after they die. That is why it is beneficial to discuss your situation with a trusted professional who can help you build an estate plan that fits your needs and ensures the money goes where you want it to after you are gone.
There are many different types of trusts that can be used in most estate plans, which help protect the heirs from creditors, keep the estate from being taxed on the gains that aren't realized (because they haven't been sold), and ensure the money goes where you want it to after your death.