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Because We're "All About That Basis!"

By her own account, Meghan Trainor’s song “All About That Base”, makes a statement that a woman with a large, well, “base” can still be super-attractive. Certainly, it’s true for Trainor herself. As a woman with a less-than-Barbie-like-physique, I liked the original song with its quirky and punchy lyrics and, of course, persistent bass notes. As a closet fan of the original, pre-Disney Star Wars (and I’m dating myself there), I am also fond of the parody: “All About That Base (No Rebels)" and fully agree with the comments from people who would have eagerly joined the Dark Side if the emperor and his goons had looked like the dancers in the parody video. As it happens, assets with a large base(is) CAN be very attractive when it comes time to sell them because the larger your base in the asset, the less tax you are going to owe the IRS, an agency which most people secretly admit to associating just a bit with the Dark Side. Moreover, to push the segue just a bit further, as an investor it is you who need to be “All About That Base(is)”. You need to keep track of your basis in everything you own from your real estate (as we discussed last week) to your cars and collectibles to your financial assets, including stocks, bonds, mutual funds, exchange traded funds, Real Estate Investment Trusts (REITS) and similar. Knowing your basis is important, regardless of whether the investments are held in taxable or tax-deferred or tax-free accounts. It is even true for investments held in life-insurance policies and annuity contracts.

We talked last week about how the basis of an asset generally starts as the price you pay to acquire the asset, and how that basis must then be adjusted up for additional investments you make in the asset, or down for circumstances that reduce its value. Sometimes, though, the starting point for calculating an asset’s basis is NOT its purchase price. The main instances, when this occurs, are when the asset is a gift (during the donor’s lifetime) or a bequest (after the donor’s death). Each of these two circumstances requires a different method for calculating basis, although it is easy to conflate or confuse the two processes.

When you receive a gift from a living donor, the general rule is that the donor’s basis in the gifted asset transfers directly to you and becomes your basis. So if Aunt Sally buys stock in XYZ company for $10/share and then gifts it to me when the price has risen to $20/share, my basis in the stock is $10/share, the same as hers originally was. If my parents buy a piece of land for $50,000 and make improvements on that are worth $10,000 and then my parents gift the piece of land to me, my basis in the piece of land is $60,000 = the original price my parents paid for the land plus the value of the improvements they made. Although land itself is not depreciated, improvements to it usually are depreciated, so my basis might be less or more, depending on the time lapse between the improvements and the gifting. For the purpose of this example, let’s say they gift it to me immediately after making the improvements.

There are two exceptions to the rule that the donor’s basis in a gift becomes the donee’s basis. The first exception is when the fair-market value of the asset at the time of the gift is less than the donor’s adjusted basis. In this case, the basis depends on whether the donee eventually sells the asset for a gain or a loss. Let’s say that Aunt Sally’s XYZ stock is only worth $8/share, when she gifts it to me. If I later sell the stock for $12/share, then the basis I use to calculate my gain is her original basis of $10/share and I report a $2/share gain. If the stock continues to perform poorly and I eventually give up and sell it for $6/share, then the basis I use to calculate my loss is the fair-market value at the time of gifting, which was $8/share and I report a $2/share loss. If my eventual sales prices are between Aunt Sally’s original basis of $10/share and the $8/share value it had when I received it, then I have neither a gain nor a loss. This might sound familiar from last week’s blog.

The second exception to the donor’s basis, transferring to the donee, is likely to be quite rare these days, since the so-called “unified tax credit”, which applies to both estate taxes and gift taxes, is so high following the implementation of the Tax Cuts and Job Act. This exception says that if the donor had given so much away that s/he has to pay gift tax on a gift, then the basis of that gift is the donor’s basis PLUS the share of the gift tax, attributable to the appreciation of the asset between the time the donor acquired it and the time s/he gifted it. Here’s how that would work. Suppose my super-rich uncle has given away so much to our extended family that he has already exhausted the unified lifetime gift/estate tax credit and his current-year gift to me is more than the $15,000 annual-per-donee gift-tax credit. In this case, he will then pay gift tax and part of that tax will be added to my basis. So, my uncle has already given away $11.4 million in his lifetime. Now this year, he gives me a gift of $25,000 of stock in which his original basis is $10,000. Of his gift, $15,000 of the stock is covered by the annual gift-tax exclusion. He owes gift tax of $2,000 on the remaining $10,00 of the gift. We calculate what portion of his gift tax adds to my basis, by taking the stock’s appreciation of $15,000 divided by its current fair market value of $25,000. This gives us a multiplier of 0.6. So, 60% of the gift tax of $2,000 or $1,200 gets added to his original basis of $10,000 to give me my basis of $11,200. Note that spouses can gift tax-fee in unlimited amounts to each other. Also note that charitable donations are NOT gifts for the purpose of gift tax or the unified credit.

The basis of an asset received through inheritance is generally the fair-market value of the asset as of the date of death of the donor. Under some circumstances, inherited assets may be valued at an alternative date, six months after the date of death. This “mark-to-market” will often result in a “step-up” of the basis, but it may also result in a “step-down”. Suppose my super-rich uncle leaves me that $25,000 of stock as an inheritance. Again, his basis in the stock is $10,000. At his date of death, when the stock effectively passes to my ownership, my basis in the stock becomes the $25,000 that the stock is worth at that time. If he had, in addition, left me a different stock for which he originally paid $10,000 that was only valued at $8,000 at his date of death, my basis in that second stock would be $8,000. Note that certain assets are not eligible for this kind of “step-up” (or “down”). Most notable among the exceptions are IRAs and other retirement assets. This is because the now-deceased donor never paid income tax on these assets during her/his lifetime. Basis is important with regard to these kinds of assets too, but with different implications, which we will discuss next week.

If you sell an asset, whether you originally obtained it by purchase or as a gift or as an inheritance, the IRS will want to claim its share of any gains. If the item is a business use or an income-generating asset, you may be able to deduct a loss. In order to minimize the gains on which you will owe taxes and to maximize any loss you may be able to deduct, you must be “All About That Basis.” After all, at tax time, you’d rather be partying in pastel like Meghan Trainor’s crew than feeling like your bank account’s been hit by the IRS the way Alderaan was by the Death Star super-laser.

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