A Basis for Decisions

Michael Perry

I’VE WRITTEN BEFORE about harvesting tax losses and using them to offset the gains from selling other investments. We have a bit of a sprawling portfolio, with numerous small positions and lots of embedded capital gains.

Gradually harvesting gains would simplify the portfolio and make it more tax-efficient. And if we do so during these early retirement years, while our income is low, and if we can partially offset those gains with realized losses, we should be able to harvest gains at low rates—and perhaps even pay 0% in capital gains taxes.

But should we sell? Lately, I’ve come to realize that—from a long-term tax perspective—it may be better to leave the gains alone, especially since we’re residents of a community property state. Living in such a state may also argue for combining individual taxable accounts into joint accounts.

There are nine community property states: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin. The other 41 are separate property states. In a community property state, all property accumulated during a marriage is considered the property of both partners. This is a key consideration in a divorce and the resulting division of assets. But it also has important implications for investment and estate planning.

As many readers know, when the owner of property dies, that owner’s heirs get a step-up in cost basis on inherited property that’s held outside a retirement account. For example, if I bought a vacation home for $300,000 that’s worth $500,000 today, I would have a $200,000 capital gain if I sold it. Likewise, if I bought 1,000 shares of ABC company at $100 a share and they’re now at $150, I’d have a capital gain of $50,000 if I sold today.

But if I wake up today planning to sell but instead die before doing so, my heirs inherit the house and the stock at today’s value. Result? When they sell, their cost basis will be today’s value, not my original cost basis. This step-up means the gains between my purchase and my death go untaxed. As you can imagine, on assets held for many years, this can be a huge tax savings.

The above is true regardless of whether one lives in a community property state or not. Here’s where the state of residence comes into play: In a community property state, assuming my heir is my spouse, the step-up occurs not only on property owned by me, but also on the full value of property we own jointly.

How does this work? Let’s say that, in addition to the shares of ABC company I own in my taxable account, my spouse owns shares of XYZ company in hers. Since those shares are in her own individual account, she gets no step-up on XYZ when I die. Instead, I would get a step-up when she dies. But let’s say we held both these stocks in a joint account. In most states, the step-up in the joint account would be limited to 50% of each position. But in a community property state, the surviving spouse would get a full step-up on both holdings.

In the individual taxable brokerage accounts that my wife and I own separately, we have significant capital gains, so—from an estate planning perspective—it makes sense to combine them into a joint account or to change the account registration on both accounts to make them joint. That way, when either of us dies, the survivor gets a full step-up on everything outside our retirement accounts. It could also simplify the portfolio a bit.

What are the possible downsides of combining accounts?

  • Both parties will have full control of all assets. If this is a concern for you, you probably shouldn’t do it.
  • You’d lose the cybersecurity benefit that comes with having assets housed in accounts with separate login credentials.
  • Moving to a separate property state later means you’d no longer get the full step-up on jointly held assets.
  • It would complicate a potential divorce and might mean surrendering greater wealth than you otherwise would.

For us, combining accounts seems like a good idea for the larger step-up alone. If we did so, we might choose to forgo realizing capital gains during our low-income years, knowing that there will eventually be a step-up on everything. Instead, we could use these low-income years to maximize Roth conversions.

Michael Perry is a former career Army officer and external affairs executive for a Fortune 100 company. In addition to personal finance and investing, his interests include reading, traveling, being outdoors, strength training and coaching, and cocktails. Check out his earlier articles.

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