“Cost basis” is the term used to describe the original cost of an asset. It is used to determine the taxable gain on the sale of that asset. For instance, if you purchased a parcel of vacant real estate in 1980 for $50,000, your cost basis in the property is $50,000. If you sell the unimproved parcel of land for $150,000 (its fair market value), your taxable gain would be $100,000; the sale price less the cost basis ($150,000 – $50,000 = $100,000). You would therefore be subject to capital gain tax on $100,000.
In situations where property is used for business purposes, the cost basis must be reduced by the depreciation taken against the property during the period of business use. When you give an asset away during life, the recipient of the gift assumes your original cost basis. For example, if a father gave his son the real estate we discussed above, the son’s cost basis would also be $50,000. If the son likewise sold the property for $150,000, he, too, would have a taxable gain of $100,000.
However, when you leave an asset to someone upon your death, the recipient receives what is referred to as a step-up in basis. The step-up in basis is the fair market value of the asset on the date of the decedent’s death (or on the date 6 months after death if the alternative valuation date is used). Using the previous example, if the father died and left the property to his son upon his death, the son would receive a step-up in basis in the property, which would be the $150,000 fair market value. If the son subsequently sold the property he inherited from his father for its fair market value of $150,000, the son would have no taxable gain. Although it makes sense at times to give away assets during life, one must consider the possible income tax ramifications to the recipient of the gift on the subsequent sale of that asset. In many cases it is preferable to leave an asset upon your death rather than to give it away during life to take advantage of the step-up in basis rule.
Many people give away assets to children during their life to avoid the delays and expenses of probate upon their death. In doing so, they lose advantage of the step-up in basis rule. A better alternative may be to create and fully fund a Living Trust during the parents’ lifetime and leave the assets to children upon their death. The assets in the Living Trust would pass to the children free of probate, and they will receive a full step-up in basis