Fixing an Old Trust to Avoid Capital Gains Tax for Heirs

happy family with grandparents and children

One of the most disruptive proposals put forth last year by Congress was the elimination of the tax-free basis step up at death. Luckily for many of our clients, the legislation was never enacted. People all over the country benefit from basis-step up when they inherit low basis property which they can turn around and sell without paying taxes on the gain.

Under current law, taxpayers pay taxes on capital gains when they sell an asset for a profit and realize a gain. For example, a person buys a house for $100,000 (basis) and twenty years later it is worth $1 million dollars. Capital gains tax is owed when the house is sold. The amount of capital gains tax depends on the owner’s income tax bracket – ranging from 25% to 39% in New York State.

If the owners of the house in the above example held onto the property until their death, the asset’s tax basis is “stepped up” to fair market value on date of death. Those who inherit the asset only must pay capital gains on any further increases in value. This is the reason estate planning attorneys warn clients never to “gift” their home to a child. Gifts have “carry over” basis from the donor and do not get the step up and when the child sells the gifted property, they have to pay capital gains tax.

Estate Tax vs. Capital Gains Tax

There is a push-pull between stepped up basis and estate tax. To get the stepped-up basis, the assets must pass through the decedent’s estate. Once assets pass through a decedent’s estate, there is potential estate tax. But the federal estate and gift tax exemption is at an all-time high of $12.06 million per person. This allows for stepped up basis planning that may not have been available pre-2017 when the estate tax exemption was much lower.

A married couple’s Trust or Will that utilize a credit shelter trust to save on estate tax is a good example of a trust that needs updating. The classic A-B trust structure splits assets into a marital share and a non-marital share. The marital share qualifies for the unlimited spousal deduction. The marital share, either left outright or in trust, gets a stepped-up basis when it passes through the surviving spouse’s estate at death and is also subject to estate tax. The non-marital share captures the estate tax exemption amount in a credit shelter trust.  Any assets in the credit shelter trust do not get a step up in basis at the surviving spouse’s death but are pass estate tax free.

What if the credit shelter trust holds low basis assets? If the surviving spouse’s estate is under the estate tax exemption amount, then it may be more beneficial to get the stepped-up basis.  In that case, it is better that the assets pass through the surviving spouse’s estate, so heirs avoid capital gains. This similarly applies to existing irrevocable beneficiary trusts created for adult children.

The question is which do you choose. When the choice is clear, we can amend the trust to get the stepped up basis. If it is not so clear, we can add flexibility by including a trust protector with the power to cause the step up if needed or use a formula general power of appointment.

How Can We Fix an Existing Irrevocable Trust?

At the grantor’s death, a trust is generally irrevocable. However, depending on the language in the trust, there are methods for amending the trust to trigger stepped up basis. Estate Planning attorneys have various tools at our disposal, including utilizing lifetime powers of appointment, decanting, and trust protectors. Anyone who has a trust with low basis assets should set up a consultation to review whether this type of change is necessary and desirable.

Burner Law Group, P.C.

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