Why a step-up in cost basis can affect taxes

A step up in cost basis can dramatically affect taxes because it amounts to an increase in the value of wealth passed between deceased and living persons. The step up in cost basis regulation is contained within Title 26, Subtitle A, Chapter 1 of the U.S. code alternatively named the I.R.S. tax code. This regulation requires property to be adjusted to fair market value following the death of the owner, but is capped at no more than $1.3 million in so far as the tax code permits.

Major disadvantages of step ups in cost basis is the amount of wealth that is taxed either via inheritance tax, or estate tax. An advantage however, is that realized capital gains can shrink lowering the resultant capital gains tax for the beneficiary responsible for liquidating the property.  Even with a reduction in capital gains tax however, the step up in cost basis ends up making an estate and inheritance cost more. Since inheritance and estates are sometimes taxed, the affect can still increase the amount of taxes due.

The step up in cost basis is an important aspect of estate tax planning and individual tax strategy. Being aware of how it can affect taxes and the methods by which it may be reduced or beneficial is key to making the most of this financial requirement. Estate planning is particularly relevant to step ups in cost basis because the financial instrument in which wealth is held and through which it is transferred affects how the property will be taxed regardless of the step up in tax basis.

Several financial instruments may be utilized to bypass immediate estate, capital gains and inheritance taxes. Examples of these estate planning tools include family limited partnerships, various forms of trusts, and gifting.  Although not all financial instruments avoid taxation, they can defer taxation until a suitable tax strategy has been developed. When estates are valued below a certain amount, neither the estate or inheritance tax may be applicable making a split estate an option to consider.

Depending on which state a beneficiary or beneficiaries live, the step up in cost basis may affect taxes differently. For example, not all U.S. states have an inheritance tax. Inheritance and estate tax may in some cases be avoided when held in joint tenancy. Since two or more persons own the property, the property does not transfer and is therefore not an inheritance per se because it is already owned.

As tax regulations are updated and changed, the step up basis on assets can affect taxes differently. For example, in 2010 the estate tax rules are set to expire thereafter reinstating the taxation of estate value. Specific taxes to be aware of when it comes to step ups in cost basis are capital gains tax, inheritance and estate tax, in addition to value limits and caps on transactions relating to such. These taxes can reduce the value of an estate significantly. Navigating the tax strategy and financial options with a skilled and knowledgeable financial professional may be of great value in some circumstances.

Sources: 

1. http://bit.ly/c2ncMG (Cornell University Law School)
2. http://bit.ly/cRsFXK (Estate Find Law)
3. http://bit.ly/c0XnQo (Bankrate.com)
4. http://bit.ly/auDihg (Avoid probate.com)

How to Determine the Cost Basis for Tax Exempt Funds

The cost basis of tax-exempted funds pertains to 1) earnings yields through mutual funds and/or retirement and/or insurance instruments that incur income from tax free investments, 2) Accumulation of earnings that are reinvested within a fund and 3) sale of funds that garner tax exempt dividend income. In other words, yield, ownership and capital gains of tax-exempt funds are subject to different taxation rules and cost basis calculation.

To illustrate what a tax-exempt fund is, the example of a mutual funds that itself invests tax-exempt financial instruments can be used. Such a fund may invest, trade or reinvest in a number of financial instruments that may yield earnings that are taxable, non-taxable or a combination of both. Such being the case, not all yields through tax-exempt funds may be tax free as this depends on the types of investments within the fund, the management of the assets within the fund, and local, state and federal laws.

Earnings from a tax-exempt fund that themselves are non-taxable and re-invested into the same fund do not increase cost basis but rather market value if the value of the fund stays the same, falls less than the value of the reinvested earnings or rises. This increase in market value is an unrealized capital gain and only become taxable following realization.

Furthermore, while earnings within a tax-exempt fund may be taxable, potential gains made from the sale of the fund are usually not. However, in the case of certain retirement and insurance products, capital gains may either be tax deferred or tax exempt due the tax protection provided within that retirement instrument.

Determining the cost basis for tax-exempt funds is a multi-tiered process involving 1) the determination of tax exemption and 2) the cost of those tax-exempt funds. And 3) the realization, un-realization or re-investment of income earned with a given tax year (www.investopedia.com).

Cost basis is a calculation that can be useful in a number of financial scenarios that may benefit an individual, tax payer or business depending on if the cost basis of an asset, investment, capital expenditure, income after cost etc. are favorably valued. A few of the areas in which cost basis can be beneficial in terms of tax exemption are as follows:

• Tax planning for individuals, businesses and non-profit businesses
• Investment valuation in deferred or non-taxable retirement instruments
• Bookkeeping of cost basis of transactional proceeds through non-taxable instruments
• Asset management and cash-flow cost determination
• Preparation of quarterly, annual, personal or business financial documents

Determining tax exemption status

There are several types of tax-exempt funds and financial instruments, some of which may have differing yields. The first step in determining cost basis of these funds is to clarify what, how and why certain funds are tax-exempt. The following list of tax-exempt financial instruments illustrate the various type and reasons for tax exemption.

• Tax-exempt mutual fund: Invests wholly or in part, in tax exempt financial instruments
• IRA or retirement plan that incurs income through a tax-exempt fund
• Hedge fund(s) that invests in tax-exempt funds
• Exchange traded funds with tax-exempt earnings
• Insurance policies with cash value from investment in tax-free instruments/funds

While tax exemption on earnings may be a good thing, they are not necessarily more cost effective than other funds if 1) the fees and charges associated with the funds management offset the tax savings and 2) other funds managed by the same company yield a higher after tax return for the same investment risk level.

Calculating cost basis

Cost basis can be calculated in terms of yield and capital investment. Applying cost-basis calculations to both can better determine the quality, value, and opportunity cost of the investment. The following illustrates cost basis calculations based on 1) taxable cost basis of yield, and 2) tax-exempt cost basis of investment.

• Taxable cost basis

Calculating the taxable cost basis of a tax-exempt fund yield cost basis can be determined by taking one's taxable income rate, for example 28% and then using that to determine the pre-tax yield if the fund where taxable (money.cnn.com) For example, Fund A yields an annual not taxable return of 2.88%.

If the earnings were to be taxed at 28% an equivalent taxable yield of 4% would be required to create the same 2.88% return i.e. 2.88%/1-.28=2.88/.72=4%. Alternatively, a funds that's earnings are taxable with a yield that is also 2.88% would have an after tax earnings lower than the tax exempt fund i.e. 2.88% * .28=.8064; 2.88%-.8064=2.07% actual return.

• Tax-exempt cost basis:

Since cost of an investment is also relevant for taxation matters, this original cost basis is also useful in addition to taxable and not-taxable cost basis of yield. Since market prices of tax-exempt funds can vary with fluctuations in market conditions such as bond price movements, interest rates, economic growth rates etc. actual values of funds can vary.

However, cost basis of tax-exempt funds is not based on market value hence the purchase price is usually used in determining cost basis (investopedia.com). There are of course exceptions to this rule of thumb, particularly in the case of reinvestment of capital gains and/or non-taxable dividends into taxable funds. Calculating the tax-exempt basis of such a fund is thus a simple matter of purchase price.

Cost basis adjustment on reapplication of income after unrealized reinvestment of earnings

In situations in which capital gains are realized after realized tax-exempt earnings of tax-exempt funds are reinvested in the same fund within the same or a following tax year, the cost basis of the reinvestment will reflect a higher amount. (investopedia.com) For example, on January 1, Mr. Jones buys 1000 shares of XYZ tax-exempt fund at a price of $27.50/share with a $25.00 commission. The funds are within a non-retirement investment account that consequently is subject to taxable earnings.

If the fund increases in market value by $1.00/share and incurs a non-taxable dividend income of .50 cents /share and Mr. Jones holds the fund until the following year in which he earns another $500.00 non taxable dividend income and a $1000.00 qualified end of year income redistribution. Since the non-taxable earnings were reapplied to the fund through income reinvestment, the cost basis of that investment rises to $27,500 +$2000=$29,500.00. Jones then sells 1071.42 shares (averaged reinvested dividend of 28.00/share) at $28.50 for a price of $30,535.71. Since the cost basis was adjusted up to $29,500 and the fund was held for longer than a year, the tax rate and total taxable income declines.

Summary

In summary, cost basis can be calculated on yield, investment and reinvested earnings. Calculating cost basis in terms of yield allow for financial comparison with similar taxable related investments. Moreover, cost basis varies with investment vehicle the tax-exempt is bought through, and the investment status of the fund i.e. original or reinvested capital. Since taxation of funds differ based on what tax free instruments are invested in, earnings on tax-exempt funds may be either partially or completely tax free.

Determining exactly how earnings will be taxable depends on the fund itself, the tax laws within one's state, tax bracket and investment strategy. Additionally, reinvestment of earnings and capital gains can lead to a higher overall cost basis that can be reflected in individual tax calculations. Such increases in cost basis of tax-exempt funds that also reinvest dividends and qualified distributions may consequently be beneficial to lowering taxable income within some tax planning strategies.

Sources:
1. http://www.investopedia.com/terms/c/costbasis.asp
2. http://www.fairmark.com/mutual/exempt.htm
3. http://money.cnn.com/2004/12/10/pf/expert/ask_expert/index.htm
4. http://www.ehow.com/how_2006650_invest-triple-tax.html
5. http://www.prudential.com/view/page/12608?param=12624