By: Jennifer Denchak Wetzel, Esquire
“Basis” is a tax term used to describe an owner’s financial investment in a property. When that property is sold, the basis is the gauge for determining whether there is gain or loss from the sale and the resultant income tax consequences of the transaction, if any. Within most farm transition plans, farm assets are transferred to the younger generation. The method of transfer will determine the recipient’s basis in those farm assets.
Lifetime transfers of farm assets can occur through sale, gift, or a combination of the two. If the younger generation purchases the farm assets, the purchase price usually establishes the basis of the assets in the purchaser’s hands. If the older generation gifts the farm assets to the younger generation, the recipient receives a “carry-over” basis, which is the same basis that it was for the older generation. If the younger generation sells these farm assets that were acquired by gift, there could be significant gain and income tax consequences.
At-death transfers, on the other hand, provide a significant tax benefit to the recipient through what is commonly referred to as “stepped-up basis.” The recipient of inherited property receives a basis in that property equal to the fair market value at the time of the deceased owner’s death. If the recipient sells the farm assets that were acquired through an at-death transfer, there may be no gain and no income tax consequences.
To illustrate the above, consider the following: Parent owns a tract of farm real estate that was purchased for $50,000 in 1970. The farm is now valued at $1,000,000. If parent gifts the farm real estate to child during lifetime, child receives a basis in the property of $50,000. If child then sells the property, there will be $950,000 of gain subject to income taxes. If, instead, Parent dies owning the farm real estate and transferring that real estate within his/her Will to child, child now has a basis of $1,000,000. A subsequent sale for $1,000,000 will result in no income tax consequences. The savings in this example between an at-death transfer and a lifetime transfer could be over $200,000.
The concept of stepped-up basis applies not only to real estate, but also to assets such as equipment, livestock, inventories and entity interests (LLCs, partnerships, corporations). With certain assets, the new owner of the property can take advantage of the increased tax basis to obtain additional depreciation expenses thereby reducing both income and self-employment taxes.
The determination of how and when to structure a farm transition is complex and unique to each farm family. Basis consequences are just one of many factors to consider. However, if an at-death transfer is planned, or if you have just inherited property, it is important to be aware of and take advantage of the benefits of stepped-up basis, which can be significant. Stepped-up basis may also be applied to property received by a surviving spouse at the death of the first spouse to die.
Many farm families and their attorneys overlook the stepped-up basis factor in the farm transition process. Mette, Evans & Woodside attorneys are knowledgeable about the tax implications of lifetime and at-death transfers, and are able to assist you to reduce potential income tax liability and to increase tax savings.