Real estate, stocks and bonds, are a few examples of investments typically made with the hope of earning a profit at some point in the future when the asset is sold. However, be sure that when you decide to sell those valuable assets, and you make that anticipated profit, the federal government will be waiting to take its share. This is known as the “capital gains tax.” Let our Los Angeles estate planning lawyers explain how this works.
Understanding capital gains tax is important for your estate plan
Understanding the capital gains tax, and how the IRS calculates it, can be helpful in finding ways to lower the amount of capital gains tax you will likely owe once you sell your assets. Taking advantage of a step-up in basis is one way to minimize your losses.
When is the capital gains tax assessed?
When the sale price for an asset is higher than the initial purchase price, meaning that a profit has been earned, the IRS calls that profit a “capital gain.” For instance, if you purchase a watch for your husband on your anniversary for $2,000, and you later sell the watch for $3,000, your capital gain is $1,000. Upon the sale of the watch, the IRS will impose a tax equal to a percentage of your capital gain. The tax is only imposed, though, when the capital gain is actually “realized.” In other words, the mere fact that your assets increase in value, but have not been sold, the capital gain has not yet been realized and the tax will not be imposed.
Are all assets taxable?
The capital gains tax is only imposed on the sale of a “capital” asset. This term is defined very broadly by the IRS as “almost everything you own and use for personal or investment purposes.” The most common taxable assets are securities, real estate, and valuable collectibles. If you sell real estate or other property, either for personal or business purposes and profit from the sale, those will qualify as a capital gain, as well.
How to Lower Capital Gains Taxes
Although making short-term investments, with higher interest rates, may seem like the best investment strategy, after the capital gains tax is imposed, you may be left with less profit than you expected. One of the common ways to lower capital gains taxes is to avoid short-term investments. Long-term investments nearly always have a lower tax rate. If you fall in the lowest tax bracket, you will likely pay no taxes on long-term capital gains. Another way to lower your capital gains tax is to shelter as much of your income as you can in tax-deferred retirement accounts. Retirement accounts, such as 401(k)s, Roth IRAs and Traditional IRAs are great examples of accounts that you can buy, sell and exchange within the account itself. In doing so, the IRS will not impose the capital gains tax.
What is a Step up in Basis?
The step up in basis is a readjustment of the value of an appreciated asset, upon inheritance, for tax purposes. A step-up in basis means that the value of the asset will be determined to be the higher market value of the asset at the time of inheritance, as opposed to the value at the time the asset was originally purchased. For example, you inherit a house from your mother, which was originally purchased for $80,000 in 1980. At the time of her death, the home was worth $150,000. If you decide to sell the house later on, your basis will be $150,000. In other words, if you sell it later for $200,000, you will be taxed on the difference between the value when you inherited it ($150.00) and the amount you sold it for, or $50,000.
Mistakes that could eliminate your step up in basis
Although the step up in basis rule seems pretty straightforward, there are mistakes you should avoid, or you might risk losing this tax advantage. The most common mistake is joint ownership. If your children own the house with you, they will not be able to use the “step up in basis” rule, but instead, will be taxed on the capital gains for the full appreciation of the property. The same is basically true for holding the title of your home in joint tenancy with your spouse. The best thing to do is to transfer the home to a living trust, which will pass the home on to your spouse or your children upon your death.
Join us for a FREE seminar today! If you have questions regarding estate planning, trust contests, or any other trust administration issues, please contact the Schomer Law Group either online or by calling us in Los Angeles at (310) 337-7696, and in Orange County at (562) 346-3209.
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