If you have read the newspaper or listened to the news at all lately you have heard the term "stepped-up basis." This is a phrase that frequently comes up in probate, estate planning and inevitably in conversations about taxes in general. Recently it has been the subject of much discussion surrounding President Obama's new tax proposals. So what is it?

Basis for tax purposes is the amount of your investment in property. For example, if you buy a piece of rental property for $100,000, your basis in the property is $100,000. Your basis is the starting point for any calculations of loss or gain when you sale, exchange or dispose of the property. Under this same scenario, not accounting for any adjustment in basis that may be available due to depreciation and/or capital improvements, if you sold the rental property five years later for $200,000, then you would have capital gains of $100,000.

What happens if you decide you want to make a lifetime gift of your rental property to one of your children? When you make a lifetime gift of property, the donee (the person receiving the gift) steps into your shoes and effectively takes your basis in the property. Under the above scenario your child would have a basis of $100,000 if you made a lifetime gift of the property. If she turned around and sold the property, she would have the same $100,000 capital gains as you would have for selling the property. What if you wait and give the property to your child at your death (e.g. through your Will)? When the property passes to that child at death, the child gets a "stepped-up basis;" that is, the basis in the property is now the fair market value of the property on the date of death. Under the above scenario, the child's basis in the property would be $200,000. If the child turned around and sold the property there would be no capital gains.

Texas is a community property state. At death, each spouse owns one-half of the community property and one-half will pass to that spouse's beneficiaries or heirs at law. So, how does basis work if you pass community property and separate property to your spouse at death? The surviving spouse receives a "stepped-up basis" in all of the community property, not just the deceased spouse's half and in all of the deceased spouse's separate property. This could be very significant for the surviving spouse in the case of low basis assets. For example, if the surviving spouse has a very low basis in the homestead (e.g. she and her husband bought it for $30,000 years ago and now it is worth $1million), at her spouse's death she receives the fair market value of the property as a new basis. Consequently, there will be no capital gains if she then sells the property. However, if she and her husband had sold the property during life, that would not be the case. They would have to start with $30,000 as their basis in the property. If the home is now valued at $1million, even with the $250,000/$500,000 exclusion for the sale of your homestead, there would still be capital gains tax due.

President Obama recently announced many new tax proposals, one of which is to do away with the "stepped-up basis" (a/k/a "the Angel of Death Loophole") at death. Instead of allowing the appreciation in these low basis assets to pass to the beneficiaries free from capital gains tax, President Obama has proposed to have the gain in these assets taxed on the Decedent's final income tax return (of course there are numerous exceptions and caveats to the proposal). There has been a lot of discussion about whether this is a good recommendation or not and a lot of discussion about what groups of people may benefit from this proposal and what types of assets are affected by this proposal. The rhetoric in general has been that this proposal will help the poor, punish the "rich" and only affect people who have owned Exxon stock for 50+ years. Unfortunately, it is simply not that cut and dry. Keep watching to see what happens with this proposal and how it may affect your estate planning documents.