Cost basis (n.): The original value of an asset used for tax purposes, adjusted for corporate actions, distributions, wash sale rules and income reallocation.
Seems straightforward, doesn’t it? But this simple number can make a big difference when it comes to taxes. The Internal Revenue Service uses your cost basis to calculate how much you’ve gained or lost by owning a particular asset, including tangible property and investments. You typically will owe short or long-term capital gains taxes on the gains realized when you sell the asset, if the asset has appreciated between when you purchased it and when it’s sold. Your cost basis matters when it comes to estate planning, too.
Here’s why:
Step-ups in Action
Say you purchased 1,000 shares of a tech company stock in 1980, when it was approximately $10 per share and held on to it. Decades later, the stock is now valued at $116 per share.
Scenario 1: You sell the stock yourself.
You’ll reap $106,000 in gains but also owe Uncle Sam $15,900 in long-term capital gains taxes (assuming the 15% rate, which could be higher for those subject to the 20% bracket for long-term capital gains plus the Medicare surtax).
Now consider this.
Scenario 2: You bequeath your shares to your children.
When your children inherit, they enjoy a “cost-basis step-up” to the stock’s fair market value (FMV) on the date of your passing ($116/share). The stock is also automatically considered a long-term holding, regardless of whether you yourself held it for more than a year. The step-up narrows the amount of gain that would be subject to long-term capital gains taxes if the stock appreciates further. If your children immediately sell the inherited shares, they will owe $0 in capital gains taxes, even though the stock appreciated significantly during your ownership.
Tax savings: That’s a potential savings of $15,900 with cost-basis step-ups as part of your estate and tax planning.
There are a couple of variations of cost-basis step-ups, including ones that take joint ownership of the original asset into account and one that uses an alternate valuation date. Some accounts qualify for an alternate valuation six months from the original date of death. Also, If the asset in question has lost value, a step-down will occur, so selling the asset, rather than bequeathing it, may make more sense.
Awareness of, and a short example of cost-basis step-ups is advantageous for your financial and estate planning decisions. Because taxes are complicated, it’s wise to consult with your financial and tax professionals in order to stay within the guidelines.
Tom King CFP®, CLU®, AEP® is Registered Principal of King Financial Partners goKFP.com at 222 Blue Course Dr., State College, PA. King Financial is a team of credentialed professionals specializing in retirement, investment management, wealth transfer, and estate planning. Tom can be reached at [email protected] (814) 234-3300.
The referenced example is to be used for illustrative purposes only. Individual cases will vary. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Prior to making any investment decision, you should consult your financial advisor about your individual situation. Any opinions are those of Tom King and not necessarily those of Raymond James. Raymond James does not provide tax services. Please discuss these matters with the appropriate professional.
Sources: Raymond James Worthwhile Spring 2017. Certification Financial Planner Board of Standards, Inc. (CFP Board) owns the CFP® certification mark, the CERTIFIED FINANCIAL PLANNER™ certification mark, and the CFP® certification mark (with plaque design) logo in the United States, which it authorizes use of by individuals who successfully complete CFP Board’s initial and ongoing certification requirements. Securities offered through Raymond James Financial Services, Inc., member FINRA/SIPC.© 2021 Raymond James Financial Services, Inc., member FINRA/SIPC. Investment advisory services offered through Raymond James Financial Services Advisors, Inc. King Financial Partners is not a registered broker/dealer and is independent of Raymond James Financial Services.
