The cost basis of a property is usually the value of the holding at purchase. This basis is then used when calculating capital gains (or losses) at the time of sale. The sale price minus the cost basis is called the capital gain. When this growth on the value of the property over the purchase price is realized via a sale, the capital gains are taxed at their own rate.
According to U.S. Code 1014, property which is inherited from a decedent is allowed to use as the cost basis the fair market value of the property on the date of the decedent’s death. This is what is called a “step up in basis” because the cost basis of the property is elevated to the current value. This makes the capital gains, calculated by the current value minus the cost basis, effectively $0. (Market fluctuations after the date of death will move the current value, thus incurring either a gain or a loss after a few days.) With no capital gains, it means that the property can be sold without incurring capital gains tax.
Thus, the step up in basis to date of death forgives a lifetime of growth from the capital gains tax.
When it comes to investment accounts, the type of account ownership changes how the shares are stepped up.
If the account is an individual account and the owner dies, then 100% of all the holdings in the account receive the step up in cost basis.
If the account is a joint account and one of the owners dies, then only 50% of all the holdings in the account receive the step up in cost basis. If there are multiple owners, then only the decedent’s share receives the step up, 25% in the case of four owners. The exception to this rule is if you live in a Community Property state. The community property status means that all assets in a joint account among spouses can receive the step-up in cost basis on the death of either spouse. (This is called a “double step-up in basis.”)
If the account is owned by a living trust granted by the decedent, then it is treated as having passed directly from the decedent and follows the joint or individual rules according to how many grantors there are.
If, however, the account is owned by an irrevocable trust, then the trust is treated as its own entity. This means the assets are not passing from the decedent; they are simply owned by the trust. For this reason, no step up in basis is granted when someone dies, even if the decedent was the grantor or the beneficiary of the trust.
Once upon a time, the estate tax exemption was very low. Back in 1997, the exemption was only $600,000 and a lot of people were worried about passing over that limit and having their estate taxed. As a result, estate attorneys invented the A-B Trust strategy. In this type of estate plan, you grant a joint trust between the spouses. Then, upon the death of the first spouse, the assets are split into two trusts: A) for the survivor and B) the bypass trust. Spouses have an unlimited estate exemption so the trust that goes to the survivor can receive any amount without paying tax. Meanwhile, the bypass trust that skips the survivor can receive just the right amount to sneak under the estate exemption for that year, thus avoiding estate tax and decreasing the estate value of the survivor, increasing the likelihood that the survivor’s estate is also below the limit.
Since 1997, the estate exemption has only gone up. Now, in 2019, the exemption is $11.4 million per individual and most people who drafted their estate plan back in the early 2000s very needlessly have A-B trusts. Furthermore, beginning January 1, 2011, you became allowed to pass your unused estate tax exemption with your spouse, this is called “the portability of the estate tax exemption.”
The problem with an A-B trust is that the bypass trust is an irrevocable trust. Although there is at least a 50% step up in basis upon the death of the first spouse, the bypass trust will receive no step up in basis when the surviving spouse dies. If there is even a 5-year gap, it could mean a lot of extra capital gains tax for the heirs.
For this reason, you may want to consider redesigning your estate plan. If your estate is small enough that you don’t need to worry about the current estate limits, then consider removing the bypass trust. If you are still worried about the estate limits, discuss your concerns with your estate attorney. Trust law is very malleable. You can make a trust that does whatever you want. For this reason, there are nearly infinite ways to solve this problem; you just need an attorney talented enough to implement them.
That being said, be sure to review your estate plan for places where you create irrevocable trusts that are open for multiple years. For each such trust, ask yourself: Is what I’m accomplishing here worth sacrificing the step up in basis? If it is not, perhaps there is a better way to implement your estate wishes.
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