“Step-Up” Your Estate Tax Strategies

Please note that the following article was co-authored by Greg Allison.

One of the most common strategies employed by affluent taxpayers in a comprehensive estate plan is to gift assets into trusts. This is largely done with an eye toward removing assets from the taxpayer’s gross estate for federal estate tax purposes. While this is generally a good strategy from an estate tax perspective, it has the potential to cause income tax issues for the beneficiaries.

Under Internal Revenue Code (“IRC”) Section 1014(a), the basis of property a beneficiary inherits will be the fair market value of such property on the decedent’s death (as opposed to the decedent’s basis). For example, if the decedent bought a diamond ring in 1990 for $5,000 and at the time of his or her death in 2019 the ring is worth $10,000, the individual who inherits the ring will have a basis of $10,000. The "step-up" in basis is advantageous because if the beneficiary later sells the ring for $12,000, he or she will only have to recognize the gain of $2,000 instead of $7,000 (as the descendant would have).

Generally, assets gifted to trusts are not eligible for this basis step-up when the taxpayer passes away. So how does a taxpayer employ both estate tax planning (remove assets from estate) and income tax planning (obtain a basis step-up upon death) together? Consider the following example:

Joe Smith transferred Property 1 with a basis of $100,000 to a trust in 1990 with a current fair market value of $1 million. Joe Smith personally has a property (Property 2) that he purchased for $900,000 with a current fair market value of $1 million. Joe’s estate plan leaves everything to his daughter, Mary, upon his death. When Joe passes away, Mary will have Property 1 with a $100,000 basis and Property 2 with a $1 million basis. If Mary sells both properties for $2 million, she will recognize $900,000 in taxable gain.

What if Joe exchanges, or swaps, Property 1 with Property 2, and then passes away? The basis in Property 1 would be stepped-up to $1 million (since Property 1 would be includable in his gross estate). The basis in Property 2 would be $900,000 (not eligible for a basis step-up, since Property 2 is in the trust). If Mary sells both properties for $2 million, she will only recognize $100,000 in taxable gain.

These examples illustrate the need to review your estate planning strategies not just from an estate and gift tax perspective, but also from an income tax perspective to maximize the highly beneficial basis step-up rules upon death. Your Schneider Downs advisor would welcome the opportunity to review your estate plan in this light.

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Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax, or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice.

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