By: Ed Brown, Esq.
When planning your estate or thinking about gifting assets during your lifetime, it’s important to understand how basis and capital gains taxes work—and how smart planning can help minimize your tax exposure.
Typically, assets included in your taxable estate will receive a step-up in basis to their fair market value on the date of your death. This means that your heirs could sell those assets shortly after your passing with little to no capital gains tax.
However, assets you gift during your lifetime generally do not receive this step-up. Instead, the recipient inherits your original cost basis—the value you paid when you acquired the asset (less any depreciation you incurred on such asset). If those assets have appreciated significantly over time, this can result in a substantial capital gains tax liability when the assets are eventually sold.
Fortunately, there are several strategies to potentially reduce or defer capital gains taxes on gifted assets, not just during your lifetime, but also at your death and even again at the death of your descendants. For example, some planning techniques may allow for the basis of both spouses’ trust assets to be stepped up at the death of the first spouse-to-die, even if you don’t live in a community property state. This could enable the surviving spouse to sell trust assets with little to no capital gains tax. This is accomplished by, for example, modifying your existing garden-variety revocable trusts so that they effective give the first-to-die spouse broad powers over all or a fraction of both spouses’ assets so that all such assets get a new stepped-up basis, but carefully crafted to avoid unnecessary estate taxes upon the first-to-die spouse’s death. Also, the use of community property trusts can be explored, which are allowed in a number of states. Another design could involve a sale of assets to a completed gift trust that grants an elderly relative (who does not have estate tax concerns) broad (but controlled) powers of the sold assets. The goal there is for the sold assets to achieve a new stepped-up tax basis at the time of the elderly beneficiary’s death.
That said, not all strategies are created equal, and it’s crucial to avoid those that could raise red flags with the IRS. Also, there are risks with whether the above-mentioned strategies will be upheld if challenged (however, there are ways to enhance the likelihood of a design being successful).
Each year, the IRS publishes its “Dirty Dozen” list, which highlights abusive tax schemes and transactions that you should avoid. Some examples include:
- Monetized installment sales;
- Transactions involving Malta pension plans;
- Abusive charitable trust structures; and
- Trusts marketed under names like “643,” “pure,” or “complex spendthrift” trusts, which claim to avoid capital gains taxes altogether.
These arrangements may be promoted as a way to gain significant tax savings, but they could lead to audits, penalties, and worse if they fall outside of IRS guidelines.
Bottom line? Proper planning can offer powerful tax benefits—but it must be done responsibly and legally.