While President Joe Biden’s recently proposed “Build Back Better” brought the possibility of a reduced estate tax exemption for 2022, insufficient support for the bill precluded the reduction, leaving taxpayers with an exemption of $12,060,000 per person. Which means that under the current rules, most taxpayers will not be subject to a Federal Estate tax liability and can instead focus their tax planning efforts on reducing their Federal income tax liability. As such, the step-up in basis at death can be a powerful planning tool for minimizing an individual’s capital gains taxes from the sale of appreciated assets. For married couples, though, the death of one spouse often only results in a partial step-up, reducing the value of this tax benefit (and thereby potentially increasing taxes on the subsequent sale of assets) for the surviving spouse. But with some proactive planning, couples can take greater advantage of the step-up rules by titling their assets in a way that maximizes their likelihood of a full step-up.
The concept of the step-up is that, when an individual dies, the basis of the assets that they owned is increased (or “stepped up”) to their value as of the date of the individual’s death. And while the concept is fairly straightforward for assets owned solely by the decedent, it can become more complicated when the assets are owned jointly with a spouse. Because in most states (which treat jointly-owned assets as “separate property”), even though the assets are owned in both spouses’ names, the amount that is included in the decedent’s estate – and therefore eligible for the step-up – is only 50% of the assets’ value, leaving the original basis intact on the surviving spouse’s remainder. Notably, ten “community property” states allow for a 100% step-up in basis on all jointly-held assets (as long as they meet the definition of community property). Which means that, based on whether or not a couple happens to live in a community property or a separate property state, they may receive a full (or just a partial) step-up in basis on their jointly-owned assets when one spouse passes away.
Fortunately, for the majority of couples who live in separate property states, there is a simple strategy that can be used to potentially receive a full step-up in basis of assets upon the death of a spouse. For couples where one spouse is expected to live longer than the other, it may be possible to transfer all of the couple’s assets solely into the name of the spouse anticipated to die first. Upon that spouse’s death, 100% of those assets would be subsequently included in their estate and therefore subject to a full step-up when the surviving beneficiary spouse receives the assets.
As with many seemingly simple strategies, however, the transfer-and-inherit strategy between spouses comes with complications and exceptions to watch out for. For example, the IRS requires that the spouse who receives the transfer of assets must own them for at least one year before they pass back to the original donor in order to receive the step-up in basis, making the strategy less useful when the spouse’s death is anticipated more imminently. Additionally, gifting assets means giving up control over how they are used and bequeathed, and so the strategy requires the surviving spouse to trust that the shorter-lived spouse will not spend the assets, give them away, or leave them to someone other than the surviving spouse at death (however unlikely that may seem at the time). And lastly, if a spouse is enrolled in Medicaid (or plans to enroll in the future), transferring assets into their name could exceed the allowable asset limit set for Medicaid eligibility, thereby disqualifying them from the program and requiring them to spend down the assets to re-enroll (making the strategy a moot point, as the assets would likely not last long enough to be stepped up at all!).
Ultimately, the difference between a full step-up in basis and a partial one (or none at all) can end out being a significant increase in the after-tax value of assets for some clients. Advisors can help deliver this value to their clients by planning and aiding with the retitling of assets (when appropriate) to take full advantage of the basis step-up. Which is important, especially because the subject of death (and repositioning assets in anticipation of death) may be complex and emotional for clients, and the role of the financial advisor often involves aiding clients to find objective solutions through difficult situations… to help clients – and their loved ones – stay on track with their goals to maximize and enjoy their wealth!Read More…