With fewer estates subject to a federal estate tax under tax reform, the focus in estate planning for many has shifted to managing income taxes upon wealth transfer. Given the current landscape, there are estate planning considerations for investors seeking tax efficiency. How assets are valued at death for income tax purposes is one area of opportunity.
As the lifetime uniform estate/gift tax exclusion doubled under tax reform (currently $11.4 million per individual for 2019), only a small percentage of estates will be subject to the federal estate tax. Since many assets when passed to heirs at death benefit from stepped-up cost basis, this is a key planning consideration to minimize potential capital gains taxes.
Here are some considerations for investors seeking to preserve step-up in cost basis on assets passed through their estate plan.
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. When lifetime gifts are made, the cost basis of assets for 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, 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 capital gains taxes.*
When making a gift to an older relative, there are factors to consider such as long-term care planning. Gifted assets would generally be subject to the asset test for Medicaid purposes. 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 in their estate plan. (Note: Under IRC Section 1014(e), the stepped-up basis rules do not apply to property acquired by the decedent through gifting within one year of death.)
Incorporate swap powers (under IRC Sec. 675(4)(c)) within irrevocable trusts. Swap powers allow substituting property of equal value into the trust. Appreciated property held in an irrevocable (non-grantor) 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.
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. 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.
Lastly, 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.
Consider 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.
Planning should be flexible
With this type of complex planning, it is critical for taxpayers to consult with a qualified tax and legal professional. It is also important to note that tax law is always changing, and there could be a risk in the future of the step-up in cost basis at death being modified or limited, at least for some taxpayers.
*Under IRC Section 1014(e) the stepped-up basis rules do not apply to appreciated property acquired by the decedent through gift within one year of death.
For informational purposes only. Not an investment recommendation.
This information is not meant as tax or legal advice. Please consult with the appropriate tax or legal professional regarding your particular circumstances before making any investment decisions. Putnam does not provide tax or legal advice.