With the large lifetime unified exclusion on estates and gifts ($13,610,000 for 2024) few individuals are subject to the federal estate tax. For those looking to efficiently transfer wealth, that shifts the focus to addressing income tax.
Specifically, for highly-appreciated assets how can we make sure step-up in cost basis at death is preserved and maximized? For example, understanding that gifting assets during lifetime will result in the cost basis of that property carrying over to the recipient (referred to as “carryover basis”). This contrasts with passing assets at death where certain property* benefits from a step-up in cost basis based on the value of the property at death. This can result in significant tax savings when appreciated property is eventually sold, since a step-up in cost basis can eliminate or reduce a capital gain that would generally be taxable.
Here are some considerations and strategies when planning for step-up in cost basis
- Identify which assets may be better suited to transfer at death. As part of a comprehensive estate and gift plan, some assets may be better suited to be gifted while living, while other assets (i.e. highly appreciated property) may benefit from a step-up in cost basis when passed to heirs at death. Of course, for those potentially subject to estate tax that will be a key factor in determining whether it makes sense to gift property while living or pass asset upon death. For more insight, see our post “Deciding how to transfer wealth to heirs.”
- Understand how step-up applies to jointly held property. Consider a married couple owning an appreciated asset as joint tenants with rights of survivorship (JTWROS) that was purchased for $100,000 years ago and is valued at $500,000 when one of the spouses passes away. Only the deceased spouse’s portion would receive step-up in cost basis. The resulting cost basis on the property for the surviving spouse would be $300,000. This is comprised of their original portion of cost basis for the surviving spouse ($50,000, representing half of the purchase price) plus the stepped-up portion of the deceased spouse’s cost basis ($250,000). If the entire property was owned by the deceased spouse, and left to the surviving spouse upon death, the cost basis of the property would have been stepped-up to $500,000. This treatment would also apply to property owned as Joint Tenants by Right of Entirety.
- Avoid large gifts of appreciated assets to younger family members. If the federal estate tax is not a risk, families may benefit from transferring appreciated assets to heirs at death to secure a step-up in cost basis. As a reminder, when lifetime gifts are made, the cost basis of assets for income tax income purposes is transferred to the person receiving the gift (known as “carryover basis”).
- Gift low-basis assets to older family members. Conversely, there may be a benefit to gifting appreciated assets to older family members. The premise behind the gift is that the older family member would, in turn, upon their death, leave the asset to the person who made the gift. The cost basis of the appreciated asset would be stepped-up at death sheltering the appreciation from potential capital gains taxes. Note that under IRC Section 1014(e) the stepped-up basis rules do not apply to appreciated property acquired by the decedent through a gift within one year of death. Also, when making a gift to an older relative, there are factors to consider such as long-term care planning. Gifted assets to the older family member would generally be subject to the asset test for Medicaid purposes for instance. Also, these assets would be subject to claims from creditors, and they would have no legal obligation to direct the asset back to the person who made the gift as part of their estate plan.
- Incorporate swap powers (under IRC Sec. 675(4)(C)) within irrevocable trusts. Swap powers allow substituting property of equal value into a trust. Appreciated property held in an irrevocable trust does not generally benefit from a step-up in cost basis at the death of the grantor. With a swap power, the trustee can swap out low basis assets held inside the trust with higher basis assets owned by the grantor. After the swap, the low basis assets held outside of the irrevocable trust could benefit from a stepped-up cost basis upon the grantor’s death. The rules around incorporating swap powers within a trust are complicated so it is critical to work with a qualified trust planning attorney.
- Spend down retirement assets. Retirement assets do not benefit from a step-up in cost basis at death and are generally taxable to heirs who have to distribute funds under required minimum distribution rules, typically within a 10-year period for non-spouse beneficiaries. Some retirees may choose to spend down their IRAs and preserve taxable, appreciated assets for transfer to heirs. At the same time, when withdrawing more funds out of a pretax retirement account, retirees need to weigh the impact on current income taxes.
- Some assets may benefit more than others from a step-up in cost basis at death. For example, depreciated real estate, or master limited partnership (MLP) interests where the taxpayer has benefited from a deduction for depletion may be good candidates for estate inclusion to achieve step-up in cost basis.
- Be aware of discount planning. Some high-net-worth families may have pursued aggressive valuation discounts in the past to maximize wealth transfer when the lifetime gift/estate tax exclusion was much lower. These valuation discounts set a lower cost basis on these assets, which may have an adverse effect on income taxes. Valuation discounts may not be appropriate for those who determine that a federal estate tax risk will not apply.
*An asset or property that does not receive step-up in cost basis at death is referred to as “income in respect of a decedent” or IRD property. This includes retirement accounts, annuities, unpaid interest, income from installment sales, wages, and net unrealized appreciation (NUA) associated with company stock. For more detail on the topic of company stock owned within a retirement plan, see “Consider the options before taking action on company stock.”
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