Adobe Stock
My Grandpa used to tell me, “If you’re paying taxes, you’re doing something right!” There is an element of truth to that statement: If you are paying taxes, it means you are making money! In other words, having a large income tax bill can be a good problem to have. However, there are a few things to be aware of in order to avoid making big, costly tax blunders, especially when it comes to selling or gifting away assets.
John Loyd
A charismatic client of mine, upon completion of service in the military, got a job “flipping burgers” in 1968 for 90 cents an hour with a major food chain. His boss encouraged him to invest in the company, to which he replied, “Sounds great. But I don’t have any money.” His boss paused for a moment, then said, “We’ll fix that. Hop in my car.”
The boss drove to a local bank and helped my client get a $2,000 loan by co-signing the note. My client invested the entire $2,000 in the company (known for their golden arches) and never touched it. Today, that $2,000 investment is worth over $1 million. Guess what? No tax was ever paid on that massive appreciation. How is that possible?
When one passes away with nonretirement assets (that is, stocks, bonds, real estate, etc.), the heirs get a “step-up” in the cost basis to the value on the date of death of the decedent.
Like any business owner, my client dealt with the sometimes-harsh realities of running a business. Staffing issues, machine malfunctions, new regulatory procedures, and a host of other things that can sometimes cause a business owner to bonk their head against the proverbial wall. A few times, my client called and would consider “selling all” of that particular stock. This would often be on a day when things weren’t running so smoothly. I would listen to his concerns and explain to him the positive aspects of the stock, along with the hefty tax consequences if he were to sell. He would literally have a seven-figure capital gain (taxed at 20%). I also knew he was having some health issues, and while he was still going strong, a recent stroke indicated his life expectancy was likely to be shorter than anticipated. He held onto the stock, and upon passing away, his beneficiary (his wife, in this case) gets a “step-up” in the cost basis on his date of death. Long story short, tax on the entire appreciation can be avoided upon someone’s passing. In essence, one needs to be mindful of selling assets with significant appreciation if it appears that longevity is not in order.
Another issue I see is when aging parents consider gifting certain assets to their children. The rationale for this is often “to make it easier when Mom or Dad pass away.” The thought is, the asset can be re-titled while the parents are alive, perhaps avoiding probate when the parents pass. That could be true, but probate in Texas is a relatively inexpensive and a mostly painless process.
A client’s mother had inherited land more than 40 years ago near Round Rock, Texas. At that time, the mother would have received a “step-up” in basis, but since then, there had been considerable appreciation of the land value. My client called me one day and said, “Since my mom is getting up in age, she is going to gift me this land.” I nearly leapt out of my chair and said, “Hold on! Don’t do anything yet!”
I explained that when one gifts an asset, in most cases, the gift recipient will simply take the donor’s basis (sometimes referred to as a “carryover basis,” as the basis of the donor simply “carries over” to the gift recipient). In other words, my client would take on her mother’s (very low) cost basis and upon selling, would have a massive amount of tax to pay given the huge appreciation of the land over the years. However, when her mother (who was in her 80s) passed away, she could simply inherit the land, receive a “step-up” in basis of the value on her mother’s date of death, and could sell the property with zero tax on the appreciation, allowing a huge tax bill to be avoided.
In a court case in the 1930s, presiding Judge Learned Hand famously stated, "Anyone may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one's taxes." The IRS is unforgiving, and ignorance of the law is not a defense. Major financial decisions should always be coordinated with a seasoned financial and/or tax advisor to help minimize any adverse tax consequences.
John Loyd, CFP®, MBA, EA is founder of The Wealth Planner™. For over two decades, he has been providing wealth management advice to small business owners and high-income professionals. Contact him at [email protected]. Securities & Advisory Services offered through LPL Financial, a Registered Investment Advisor. Member FINRA/SIPC. Above are hypothetical situations based on real-life examples. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investments or strategies may be appropriate for you, consult your advisor prior to investing.