Since most of the population has significantly less wealth than the current estate-tax exemption amount of $11,180,000, income- and capital-gains tax planning has become more widely important than saving on estate taxes. And there’s a clever way that investors owning assets with significant appreciation might wipe out that appreciation—for tax purposes—and “reset” the basis in these assets so they never have to pay capital gains on the appreciation.
The technique, in a nutshell, is to move those assets “upstream” by gifting them to a more senior-generation family member who does not have a large taxable estate…and then inheriting those assets back from this family member when he or she dies.
If you know a bit about the tax rules of inheriting appreciated assets, the gears in your brain are spinning right now…because what I just described is a way to engineer a “step-up” in basis on the assets so that, in the eyes of the tax man, when you ultimately receive the assets back as an inheritance, you are considered to have paid much more for them than you actually did.
Here’s a more-technical description of this move. A step-up in basis of an asset is the increase in the amount that is presumed to have been paid to acquire it that Section 1014 of the Internal Revenue Code provides for upon the owner’s death. (Gifts of property, on the other hand, do not result in a step-up to the donee.) Thus, when the person who inherited such an asset disposes of it, his or her capital gain is measured by the difference between the net sale proceeds and the value as of the decedent’s date of death. For real estate owners, the increased basis also allows for additional depreciation deductions to be taken. Note that even if the decedent’s estate did not have to file an estate tax return (because the gross estate was less than the exemption amount), it is imperative to obtain and document the values of all assets at death to determine the assets’ new basis.
There are, however, some complex issues that need to be considered prior to utilizing such a strategy. First, if a person transfers property by gift to a donee and then inherits the asset back within one year, a step-up in basis will not be received. One strategy to avoid this result is for the donee to provide, in his or her will, to leave the asset in a discretionary trust for the benefit of the donee and the donee’s descendants or spouse.
Another concern is that if the value of the asset received by the donee causes the donee’s estate to exceed the available exemption at the donee’s death, estate tax will be due on the excess. As the current large exemption is scheduled to sunset in 2026 and revert to the $5 million exemption under prior law, one must consider the possible impact if the donee dies after 2025 or the appreciation of the asset after the gift date cause the donee’s estate to exceed even the higher exemption amount. In either case, the estate tax rate of 40% would exceed the capital gains tax savings of 20%—not a good outcome.
Another issue to consider is that the donee (the more-senior family member to whom the “gift” is given) is fully entitled to, upon death, leave the asset received to anyone he or she chooses—in fact, for the gift to be considered legitimate, this must be the case and cannot be prohibited by any legally binding agreement between the parties. There must be faith, in other words, that the senior family member will follow the donor’s wishes…but they can only be wishes.
This concern can be minimized if the donor creates a trust for the benefit of the donee that provides the donee with a general power of appointment that can be exercised only in favor of the donee’s creditors. The reason for this provision is that a general power such as this causes the property to be included in the powerholder’s estate (because his creditors can reach it) and thus to obtain a step-up in basis. And since the power can be exercised only in favor of creditors, it is unlikely to be exercised at all. With such an arrangement, by default, the trust would provide that the subject asset(s) be retained in further trust for the donor’s benefit.
This trust can be allocated to the donee’s generation-skipping exemption so that future distributions to the donor’s descendants do not incur any generation-skipping tax. Caution: Before granting such a power, one must consider whether the powerholder might have or incur debts to creditors (including possible medical or nursing home expenses) which would expose the assets to attachment in some states. This (and all aspects) should be discussed with a qualified estate-planning adviser.