| Question: My grandmother, recently deceased, left E, | | | | upon your death. This is the benefit of the step-up in |
| EE, & HH bonds to me, my sister, and mother. | | | | basis rule. |
| The total is approximately $600,000, under the limit to | | | | Now let's take a look at the apples growing on the |
| be taxed. However, there is substantial interest | | | | tree. They represent the earnings on your investment, |
| accrued on the bonds. What would be the best way | | | | which are taxed as ordinary income. The apples are |
| to distribute these? Should we have them changed to | | | | very much like dividends and interest that is earned on |
| our names to avoid the Capital Gains or do the taxes | | | | stocks and bonds; i.e., they all represent the earnings |
| have to be paid before distributed? Will taxes be due | | | | on your investment. |
| when we eventually cash them in? Will any taxes be | | | | Most ordinary income is taxed in the year it is earned. |
| due on the HH bonds? Are the CGT over and above | | | | However, with bonds, the interest earned each year is |
| the income taxes? Please Advise. Thank You. R. | | | | allowed to accrue untaxed until the bond is sold or |
| Answer: Dear R - First, you indicated that the bonds | | | | cashed in - very much like the apples on our apple |
| have a value of approximately $600,000 and you say | | | | tree. When you eventually do liquidate a bond, the |
| that this is "under the limit to be taxed." If you're | | | | money you receive actually represents two things: a |
| referring to the federal estate tax, I would agree - as | | | | return of your capital investment (cost basis), plus |
| long as the combined value of all your grandmother's | | | | accrued interest. In some cases, if you sell a bond |
| assets do not exceed $2 million, you don't have to | | | | rather than redeem it, you may receive a premium |
| worry about federal estate taxes. | | | | over the face value. In that case, the premium |
| From an income tax standpoint, however, you are | | | | represents an appreciation in the value of your capital |
| correct in thinking that the bonds may be subject to | | | | investment; i.e., a capital gain. |
| tax if they are cashed in. Let's go over the tax rules | | | | While the appreciation in the value of your capital |
| on this and see where we stand with respect to these | | | | investments (i.e., capital gain) is forgiven upon death by |
| bonds. | | | | virtue of the step-up in basis, the same is not true for |
| Most of us are aware of the "step-up in basis" rules | | | | the earnings on your capital investments; i.e., ordinary |
| that apply upon death. Those rules, however, only | | | | income. This type of income is referred to as "income |
| apply to capital assets. For example, if you buy a | | | | in respect of a decedent" or "IRD" for short. |
| house for $100,000 and you sell it for $250,000, you | | | | Think of it this way - if you inherit an apple tree with |
| have a capital gain of $150,000, which you report on | | | | the apples on it, you won't pay a capital gain on the |
| Schedule D of your Form 1040 in the year of sale. The | | | | appreciation in value up to the time of the decedent's |
| gain is the difference between your sale price | | | | death, but you'll pay taxes on the apples when you sell |
| ($250,000) and your cost basis ($100,000). Your cost | | | | them, the same as the decedent would have done if |
| basis is what you paid for the house, plus any capital | | | | he had lived to sell them himself. |
| improvements you make during the time you own it. | | | | So, now let's relate all this to your specific questions. |
| Keep in mind that you only pay a tax on the increase | | | | First, if you cash in the bonds, you won't have to pay |
| in the value of your capital (i.e., a capital gain) - and you | | | | any capital gains taxes because there won't be any |
| only pay the tax when the capital asset is sold or | | | | capital appreciation in the value of the bonds. Bonds |
| otherwise disposed of. | | | | are nothing more than an I.O.U. In this case, your |
| The tax laws give you a break if you hold a capital | | | | grandmother loaned money to the federal government |
| asset until death. In that case your "cost basis" is | | | | and the federal government agreed to pay her interest |
| increased to its date of death value. The practical | | | | for the use of her money. When the I.O.U. (i.e., the |
| effect of this rule is to eliminate any capital gains tax | | | | bond) is redeemed, you'll be paid back the amount |
| on the appreciation of your capital assets from the | | | | your grandmother loaned to the federal government, |
| time you acquired them until the time you die. When | | | | plus the interest earned on the loan. The interest is |
| your heirs take over your capital assets, they start off | | | | ordinary income (IRD) and is taxable to whomever |
| with a cost basis equal to the date of death value. | | | | owns the bond at the time it is redeemed. |
| In the above example, if you own the house until you | | | | Because HH bonds pay interest semi-annually, there |
| die and the date of death value is $250,000, then the | | | | probably won't be much accrued interest that you'll |
| $150,000 unrealized capital gain is forgiven entirely. | | | | receive when the bonds are redeemed. However, |
| Your heirs then take over the house with a cost basis | | | | whatever interest is accrued at that time will be paid to |
| of $250,000. If they later sell the house, their capital | | | | the holder and it will be taxed to the holder as ordinary |
| gain would be the difference between the selling price | | | | income in the year the bonds are redeemed. |
| and their cost basis of $250,000. | | | | One final point. Distributions from an estate (or trust) |
| The step-up in basis rule, as we've just discussed, only | | | | are deemed to carry out ordinary income first and |
| applies to the increase in value of your capital assets - | | | | principal second. For this reason, it is generally |
| it doesn't apply to the income earned by your capital | | | | advisable to have the estate redeem the bonds and |
| assets. In tax parlance, the increase in value of your | | | | then distribute the money to the beneficiaries rather |
| capital assets is called a "capital gain." The income | | | | than distributing the bonds directly to the beneficiaries. If |
| earned by your capital assets is called "ordinary | | | | you distribute the bonds directly to the beneficiaries |
| income." The most common types of ordinary income | | | | (which is generally done on the basis of face value), |
| are interest and dividends. | | | | each beneficiary will pay income taxes on the interest |
| One way to distinguish a capital gain from ordinary | | | | accrued on their respective bonds. Since some bonds |
| income is through the use of the apple tree analogy. If | | | | may have more accrued interest than others and, |
| you buy an apple tree and it increases in value over | | | | since each beneficiary may be in a different tax |
| the years, that increase in value is treated as a capital | | | | bracket, they will probably pay different amounts of |
| gain. The gain is "unrealized" until you sell the tree. | | | | taxes on the bonds they receive. So, even though |
| When you do sell or otherwise dispose of the tree, | | | | they all receive the same face value, the actual cash |
| you then "realize" the gain and you pay a tax on the | | | | remaining after taxes will be different for each |
| capital gain at that time. | | | | beneficiary. For this reason, you may want to have the |
| If you hold the tree until you die, the unrealized gain is | | | | estate redeem the bonds and distribute the cash |
| forgiven and your heirs take the apple tree at its value | | | | equally to each beneficiary. |