Securing a Stepped-Up Basis: Eliminating Capital Gains in Grantor Trusts

By: Edward D. Brown, Esq.

Strategies for Investors, Entrepreneurs, Estate Planners, Tax Attorneys, and Financial Advisors

The stepped-up basis is a cornerstone of effective estate planning, offering significant tax benefits by adjusting the tax-basis of assets to their fair market value at the time of your or a named beneficiary’s (named in the trust) death. However, if the assets are in a trust and such trust is not properly designed to accomplish this, those assets will not achieve the desired step-up.

This writing explores advanced strategies for securing a stepped-up basis on assets without causing estate inclusion, including a focus on the mechanics of grantor trusts, the power of substitution under Internal Revenue Code Section 675 and asset purchase strategies.

Understanding Stepped-Up Basis

Definition and Tax Implications

A stepped-up basis refers to the readjustment of the value of an appreciated asset upon certain events. Generally, when an individual passes away, the basis of property transferred to heirs is “stepped up” to its fair market value on the date of death. This adjustment eliminates capital gains tax on appreciation that occurred during the decedent’s lifetime, allowing heirs to sell the asset with minimal or no capital gains tax liability. It should be noted however that if the asset’s value had diminished in value as of the date of the death, the basis adjustment would instead cause a “step-down” in basis, which fails to achieve the intended goal. Therefore, the nature of the asset is key. This works only for appreciated assets.

Relevance to Estate Planning

For estate planners, securing a stepped-up basis can mean significant tax savings for clients’ beneficiaries. However, when assets are held in an irrevocable completed gift grantor trust—designed to remove assets from the grantor’s taxable estate while maintaining certain income tax attributes—the pathway to a stepped-up basis is not straightforward. Planners must use sophisticated strategies to maximize tax efficiency without triggering estate inclusion.

Grantor Trust Rules and Code Section 675

Grantor Trust Status Explained

A grantor trust is a trust in which the grantor retains certain powers or interests, causing the trust’s income to be taxable to the grantor (typically the trust settlor). Importantly, a trust can be structured as a grantor trust for income tax purposes while remaining a completed gift for transfer tax purposes, thereby excluding assets from the grantor’s estate.

A common technique used to cause a trust to be a grantor trust is for the trust to provide the creator of the trust (or certain other persons) with a power to substitute (or swap) assets of equivalent value with the selected trust assets. Below, we cover some strategies that allow for a step-up.

Strategy 1: Substitution of Assets Under Code Section 675

How Substitution Works

The power of substitution allows the grantor (i.e., usually the creator of the trust) to exchange low-basis assets in the trust for high-basis assets or cash of equivalent value. By substituting in high-basis assets before death, the grantor reacquires low-basis assets, which are then included in their taxable estate and eligible for a stepped-up basis at death. The trust retains high-basis assets, minimizing future capital gains exposure.

Step-by-Step Process

1. Review the trust document to confirm that the grantor has a valid power of substitution under Section 675(4).
2. Obtain a qualified appraisal to determine the fair market value of assets to be swapped.
3. The powerholder transfers high-basis assets or liquid assets (such as cash) of equivalent value to the trust, receiving low-basis assets in exchange.
4. Low-basis assets reacquired by the grantor are included in their taxable estate, receiving a stepped-up basis upon the grantor’s death.
5. The trust retains high-basis assets, which will not generate significant capital gains when they are eventually sold.

Practical Example

Suppose a grantor trust holds stock which is worth $500,000, but which has a basis of $100,000 (an unrealized gain of $400,000). The grantor also owns (or borrows) cash of $500,000. Exercising the power of substitution, the grantor exchanges $500,000 in cash for the low-basis stock. Upon the grantor’s death, the stock (now owned outright) receives a stepped-up basis to $500,000. The trust holds the cash, which has no appreciation and thus no capital gains exposure.

Strategy 2: Buying Low Basis Assets from the Trust

Rationale and Mechanics

Another strategy is for the grantor to purchase low-basis assets from the trust at fair market value. Because the trust is treated as a grantor trust, this sale does not have any income tax consequences. This also removes the appreciated asset from the trust, allowing it to be included in the grantor’s estate and eligible for a stepped-up basis at the grantor’s death, while the trust receives high-basis assets (such as cash) in return. It may be possible for the trust assets to be purchased for a promissory note payable by the grantor, but such note should be fully repaid over the grantor’s lifetime to ensure that this transaction is respected by the IRS.

Step-by-Step Process

1. Confirm the grantor’s authority to purchase assets from the trust under its terms and applicable law.
2. Obtain a qualified appraisal to confirm fair market value of the asset to be purchased.
3. The grantor pays cash (or transfers high-basis assets) to the trust in exchange for the low-basis asset.
4. The low-basis asset, now owned by the grantor, is included in the grantor’s estate and receives a stepped-up basis at death.
5. The trust holds cash or high-basis assets, minimizing capital gains exposure for future beneficiaries.

Practical Example

Assume the trust owns real estate bought for $200,000, now worth $800,000. The grantor purchases the property from the trust for $800,000 in cash. The grantor now holds the real estate (with a $200,000 basis) in their estate. Upon the grantor’s death, the property’s basis is stepped up to $800,000. The trust holds cash, which does not appreciate, preserving value for beneficiaries without capital gains liability.

Risks and Considerations

• Valuation Risk: All asset substitutions and purchases must be at fair market value, supported by qualified appraisals, to avoid IRS challenges.
• Fiduciary Concerns: Trustees must ensure that substitutions or sales are in the best interest of beneficiaries and comply with fiduciary duties.
• IRS Scrutiny: The IRS may scrutinize transactions that appear to circumvent estate tax rules. Careful documentation and adherence to statutory requirements are critical.
• Loss of Asset Protection: Reacquiring low-basis assets removes them from the trust, potentially exposing them to creditors or other risks. Then again, the high basis assets gain asset protection.
• Income Tax Consequences: While grantor trust rules generally treat transactions between the grantor and trust as disregarded for income tax purposes, planners should confirm the tax treatment of specific transactions and consult relevant guidance.

Other Thoughts

If your aim is more to maximize stepped-up basis for assets that are in a trust so that your heirs get the benefit of the stepped-up basis, there are specially structured trusts that can be designed for a married individual (beyond the scope of this writing) that allow for not only your assets to get a step-up in basis upon your death, but also allow a step-up in basis on your spouse’s assets at the same time. For example, there are “community property” and so-called “JEST” trusts designed to achieve such objective. Such trusts, however, should first be carefully analyzed, as there are some issues and other considerations to be taken into account before setting up such trusts.

Another design could involve a sale or gift of assets to a completed gift trust that grants an elderly relative (who does not have estate tax concerns) broad (but controlled) powers over the trust assets. The goal there is for the trust assets to achieve a new stepped-up tax basis at the time of the elderly beneficiary’s death, allowing the trust to then be able to sell such assets tax free.

Conclusion

Achieving a stepped-up basis on assets owned by an irrevocable completed gift grantor trust requires deliberate planning and precise execution. The power of substitution and asset purchase strategies can be highly effective when properly implemented, allowing clients to maximize tax benefits for their heirs without triggering estate inclusion. Estate planners, tax attorneys, and financial advisors should carefully evaluate each client’s circumstances, document all transactions thoroughly, and seek professional appraisals to ensure compliance and optimal results. Staying informed of evolving IRS positions and legal developments is essential for safeguarding both clients and practitioners.