Understanding the Estate Tax and Capital Gains

One of the goals of an estate plan is to avoid unnecessary taxes, whether the source of that tax is income tax or estate tax. During your life, you have acquired assets that likely have appreciated in value. When you sell one of these assets, you trigger a capital gain, which is a form of income tax. The IRS allows you to transfer appreciated assets at death, forgiving the capital gain. In other words, the capital gain you would have incurred if you sold the asset while you are alive is alleviated if sold after you pass away. This is because the purchase price is no longer the basis for calculating the capital gain. The basis for the asset becomes the value as of the date of your death.

For example, let’s say you purchased an asset for $100,000, and now it is worth $500,000. If you sell it while you’re alive, you will need to report a capital gain of $400,000. However, if you don’t sell the asset and it’s in your estate when you pass away, the purchase price of $100,000 — or the basis — is “stepped up” to the date of death value of $500,000. If the asset is then sold, the $400,000 capital gain that would have occurred during your life is eliminated.

However, there is a catch! If you have a typical “AB” trust, your beneficiaries will not receive a complete step up, and they will inherit the capital gain problem. So, why would anybody want an AB trust? Because an AB reduces or avoids the estate tax liability.

The question then is, should you include an AB provision in your trust with its estate tax protection features, or should you remove the AB provision and give your beneficiaries the income tax benefits of avoiding capital gains?

This is a difficult question to answer because it depends on the variables at the death of the first spouse. For example, what is the size of the estate? What are the capital gain consequences? What is the estate tax exemption?

Fortunately, there is a little-known provision that can be included in your trust that can reduce the estate tax liability but gives the trustee the option to avoid the income tax capital gains if estate taxes are not the issue.

The advantage of having this provision in your trust is obvious. You are not required to make a decision without access to all the facts. When you make a decision without all the facts, it’s called a bet. If you make a decision after the death of the first spouse when you have all the facts, it’s called being smart. It’s like betting on the winning horse after the race is over, the winner has been declared, and getting a free drink afterward.

If you were wondering if you have this provision in your trust, you do! We include it in every married client’s joint trust.

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