Maximizing the step-up in basis by gifting assets between spouses – Financial Planning

For the better part of 2021, the possibility of a reduced estate tax exemption for 2022 and future years seemed reasonably possible, if not likely. Ultimately, however, the Build Back Better Act (aka the “Biden Tax Plan”), which would have implemented the change, fizzled out after Joe Manchin pulled his support for the bill late in the year.

As a result, the estate tax exemption for 2022 has ballooned to $12,060,000 per person. And thanks to portability, this means that in 2022, a couple can shield more than $24 million from estate taxes without any advanced planning.

Of course, absent any changes in the interim, the current exemption amount will halve itself in 2026 when the changes made by the Tax Cuts and Jobs Act sunset (the House-passed version of the Build Back Better Act would have simply accelerated this halving to 2022). However, even if we assume that there is absolutely no inflation between now and 2026 (something that would seem to be particularly unlikely given the current macroeconomic climate), that will still leave individuals with an exemption of more than $6 million, and married couples with a combined exemption (via portability) of more than $12 million.

In short, for the overwhelming majority of taxpayers, estate tax is unlikely to be a concern anytime soon.

But just because most taxpayers no longer need to worry about federal estate taxes taking a bite out of their net worth upon death doesn’t mean that tax planning at, near and for death is no longer valuable. Rather, it just means that instead of focusing on the federal estate tax, taxpayers and advisors now have the luxury of figuring out how to minimize income taxes upon death.

When assets in a decedent’s estate receive a step-up in basis

When it comes to income taxes and death, assets can essentially be grouped into one of two categories: assets classified as “income in respect of a decedent” (IRD), and assets that receive a step-up in basis.

Common assets that are classified as IRD include retirement accounts such as IRAs and 401(k) accounts, unpaid interest, bonuses and final paychecks, gain from an installment sale, and net unrealized appreciation (NUA). These assets don’t receive any special income tax treatment at death. Instead, beneficiaries of such assets must pay income tax on such amounts when they are received.

By contrast, everything that isn’t an item of IRD falls into the category of assets that receive a step-up in basis. Such assets include physical assets such as real estate and tangible personal property; financial assets such as stocks, bonds, mutual funds, and ETFs; and digital assets such as NFTs and cryptocurrency.

To the extent that any of these assets have unrealized gains and are included in the estate of a decedent, death actually becomes a panacea for the income tax liability that would have been owed had the owner sold the assets during their lifetime.

More specifically, upon death, the assets receive a “step-up in basis” in which the beneficiary’s basis in the assets they receive becomes equal to the fair market value of the assets on the date of death. Thus, provided there is no additional appreciation between the decedent’s death and when the beneficiary sells the inherited asset, they can do so with no tax liability, regardless of how much appreciation had occurred during the original owner’s lifetime.

Example #1: Thirty years ago, Tom purchased stock in Island Corp. for $1,000. Recently, Tom passed away at the age of 90, when the fair market value of the same Island stock was worth $125,000.

If Tom’s beneficiary sells the stock when it is still worth $125,000, they will have no income as a result of the sale. The gain of $125,000 – $1,000 = $124,000 that accrued during Tom’s life will never be taxed.

One critical point, as noted above, is that in order for the step-up in basis rules to apply to an asset upon the death of an individual, that asset must be included in the decedent’s estate. If, on the other hand, an asset is deemed to be outside a decedent’s estate, then no step-up in basis will be applied, and the basis in the asset at the time of death will carry over to the beneficiary of the asset.

Example #2: Renee is the beneficiary of an irrevocable trust that was established and funded by her mother many decades ago in an effort to minimize the impact of estate taxes. Upon Renee’s death, any remaining trust assets will be distributed outright to Renee’s daughter.

The trust’s largest asset is Nook Inc. stock, which is currently worth $2.5 million. The stock was originally purchased within the trust for $50,000.

Suppose that Renee dies and her daughter receives the Nook stock. Because the stock was held within an irrevocable trust, it was outside of Renee’s estate and, therefore, will not receive a step-up in basis (even though Renee’s death was the triggering event for the stock to be distributed from the trust).

Accordingly, if Renee’s daughter sells the shares of Nook stock when they are still valued at $2.5MM, she will owe long-term capital gains tax on $2.5 million – $50,000 = $2,450,000.

By contrast, if the same stock had been a part of Renee’s estate, the $2,450,000 gain would have been wiped out by the step-up in basis.

Step-up in basis rules for jointly held property of married couples in separate property states

In many instances, married individuals choose to hold substantial portions of their investable assets within joint accounts. Such titling makes it easy for both spouses to see and transact on the account, and if we’re being honest about it, probably helps to maintain marital bliss.

Unfortunately, while the joint account structure does provide spouses with a variety of potential benefits, it’s usually not the most efficient registration for minimizing income taxes when the property is separate property (not community property, as discussed in the next section). Notably, under IRC Section 2040, when spouses have a “qualified joint interest” (which exists when they have an account registered as either “joint tenants with rights of survivorship” or “joint tenants by the entirety”), each spouse is presumed to own 50% of the account. Thus, upon the death of the first spouse, the surviving spouse will generally receive a step-up in basis on only one-half of the assets.

Example #3: Charlie and Sabrina were a married couple who lived in a separate property state and owned a taxable brokerage account structured as joint-with-rights-of-survivorship. The sole asset in the account was Maple stock, which the couple purchased for $200,000 10 years ago. Unfortunately, Charlie recently passed away, and on the date of Charlie’s death, the Maple stock was valued at $500,000.

When the stock was initially purchased in the joint account, Charlie and Sabrina were each allocated 50% of the $200,000 purchase price ($100,000 each) as basis (notably, there are no forms or actions that need to be taken to make the allocation — it just happens). Furthermore, on the date of Charlie’s death, his share of Maple stock was worth $250,000 (one-half the $500,000 total current value).

Per the step-up-in-basis rules, Sabrina is treated as though she purchased Charlie’s share of the account for its $250,000 value on Charlie’s date of death, and can add that amount to her own existing basis of $100,000.

Thus, Sabrina’s total basis after Charlie’s death is $250,000 + $100,000 = $350,000. Which means her remaining capital gains exposure is $500,000 – $350,000 = $150,000 — not coincidentally, the same gain she already had on her half of the shares, originally purchased for $100,000 and now worth $250,000.

Charlie and Sabrina’s situation reinforces the critical point that, in order to receive a step-up in basis, the assets to be stepped-up must be included as part of a decedent’s estate in the first place. Thus, when spouses jointly own separate property, only one-half of the property will qualify for a step-up upon the first spouse’s death because the deceased spouse is only considered the owner of half of those assets to begin with.

By contrast, if a married individual owns property outright in their own name, in an individual revocable living trust, or in a similar manner in which the entire value of the property is included in their estate at the time of death, then the entire value of the property is eligible to receive a step-up in basis.

Conversely, though, this also means that if 100% of an asset is solely owned by the other (surviving) spouse, and the decedent owned zero percent of the same asset, then it will not get a step-up in basis when the decedent passes away (though it would get the step-up at the subsequent death of the second spouse who actually did own the property).

Example #4: Max and Tricia are married and live in Virginia, a separate property state. They have three taxable brokerage accounts: one that is titled only in Max’s name, one that is titled only in Tricia’s name and one titled as a joint account. Each of the accounts contains CPR stock that was originally purchased for $50,000.

Unfortunately, Tricia has just passed and, on Tricia’s date of death, the CPR stock in each of the three brokerage accounts noted above was worth $200,000, leaving the couple with a total of $600,000 of CPR stock.

However, because of the three different ways in which the stock accounts were owned (titled), there will be three different basis treatments for the stock owned in the accounts, as follows:

  • The stock owned in Tricia’s name only will receive a full step-up, resulting in a basis of $200,000 on $200,000 of currently valued stock.
  • Half of the joint account will receive a step-up in basis (since it is deemed to be owned 50% by Tricia as a joint account held between a married couple), resulting in a total basis of $100,000 (step-up value for Tricia’s half of the account) + $25,000 (Max’s existing basis on his half of the account) = $125,000.
  • The stock owned in Max’s name only will receive no step-up in basis at all, because it was fully owned by Max and thus was not included in Tricia’s estate to be eligible for a step-up in basis, which leaves only Max’s $50,000 of original basis.

Thus, after Tricia’s death, Max will have a total of $200,000 + $125,000 + $50,000 = $375,000 of basis on the $600,000 total value of the CPR shares.

The community property advantage for the step-up in basis

The step-up-in-basis rules apply to assets transferred to a beneficiary by reason of the owner’s death. But the rules that determine who actually owns property are generally determined at the state level. Thus, in order to understand precisely who owns what assets to determine the federal income tax treatment, an understanding of state property laws is necessary.

The overwhelming majority of states are separate property states that use common law to determine property ownership — where ownership is simply determined by how the property is actually titled — but a number of states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin) use a different system, called community property, to determine ownership of property for married couples.

A complete discussion of community property rules could easily fill an entire chapter in a textbook and is beyond the scope of this article. That being said, community property generally consists of property that is accrued during marriage and within a community property state.

At a high level, one can conceptually think about community property as property that is owned 100% by each spouse, regardless of how the asset is actually titled. So, whether the account is titled as a joint account, or in the name of either spouse separately, if it’s community property, both spouses are treated as owning the whole thing. And since both spouses are treated as owning 100% of the asset, the assets are included within their estate and there is a full step-up in basis on community property assets upon the death of either spouse.

Example #5: Recall Max and Tricia, from Example 4, who have three taxable brokerage accounts: one that is titled only in Max’s name, one that is titled only in Tricia’s name and one that is titled as a joint account.

If Max and Tricia live in Texas, a community property state (instead of Virginia, a separate property state, where they lived in Example 4), and each of the accounts contains CPR stock that was purchased for $50,000 (each) with income the couple earned while married (“community property” funds), then even though all three accounts have different registrations, they are all considered to be community property and are each owned 100% by Max and Tricia.

On Tricia’s date of death, the CPR stock in each of the three brokerage accounts noted above was worth $200,000. Thus, the couple had a total of $600,000 of CPR stock as of Tricia’s passing.

Since each of the accounts was considered community property, Max will receive a full step-up in basis on all three accounts (i.e., the basis of the stock will increase to $200,000 in each account, for a total basis of $600,000) even the account that was only in Max’s name to begin with.

Compared to example #4, in which all the facts were the same except for the fact that Max and Tricia’s assets were considered separate property in a common-law state, there is an additional $225,000 of stepped-up basis in a community property state. And sometime in the future, when Max dies, those same shares will all be eligible for another step-up. In this regard, community property rules can appear rather attractive as compared to the rules for separate property.

Helping spouses in separate property states get a full step-up in basis upon the death of the first spouse

Clearly, the community property rules and the “double-full-step-up in basis” they offer – one step-up after the death of the first spouse, and then another after the second spouse – offer a real advantage with respect to minimizing capital gains taxes. But what about couples living in the other 40-plus states that use common law to determine property ownership and not community property rules? Can they get double step-ups too?

Maybe, but it will generally take a bit more proactive planning.

Example #6: Norman and Irma are married, live in a separate property state, and have three taxable brokerage accounts: one that is titled only in Norman’s name, one that is titled only in Irma’s name and one that is titled as a joint account. Each of the accounts contains CLP stock that was purchased for $200,000.

CLP stock has performed well for the couple and today the CLP stock in each of the accounts noted above has risen to $500,000. Thus, the couple owns a total of $500,000 × 3 = $1.5 million of CLP stock with a combined basis of $600,000.

Norman is not in the best of health, and that doctors have given him about two years to live. Irma, on the other hand, is still in excellent health and, according to Norman, “will live to be 150.”

The couple takes no action on moving their assets and, two years to the day later, Norman passes. The CLP stock in each account is still worth $500,000. If, like most couples, Norman has left all of his assets to Irma (and vice versa), Irma will receive the following treatment (akin to Example 4, earlier):

  • A full, $500,000, step-up in basis for the CLP stock that was held in the account in Norman’s name only;
  • A half step-up in basis on the CLP stock ($250,000) in the joint account, to be added to her own existing basis ($100,000) for a total of $350,000 of basis; and
  • No step-up in basis for the CLP stock held in the account that was in her name only, leaving her with the original $200,000 of basis.

Thus, Irma now has a cumulative basis in CLP stock of $500,000 + $350,000 + $200,000 = $1,050,000.

Notably, if she were to liquidate her total $1.5 million position in the investment after Norman’s passing, she would still be “stuck: with long-term capital gains on $450,000 of gain, which could easily create a $100,000-plus tax bill when factoring in federal capital gains rates, the 3.8% surtax on net investment income, and state income taxes.

One simple trick to try and get a double step-up in basis is to do some pre-death movement of appreciated assets between spouses. More specifically, to move appreciated assets from assets held in joint accounts or in accounts held in the to-be-surviving spouse’s name only, to accounts in only the first-to-die spouse’s individual name.

The idea of this strategy is that by having all the assets owned outright by the first-to-die spouse, that spouse’s assets — which are now most/all of the couple’s assets after the transfers — receive a full step-up in basis. Those assets can then be left back to the surviving spouse, who receives back via inheritance her original share of the assets (along with the deceased spouse’s share). And upon that surviving spouse’s passing, another step-up in basis will be available on all of her assets for future beneficiaries as well.

Example #7: Suppose that Norman and Irma, from Example 6 earlier, engaged in some savvy planning instead of taking no action upon Norman’s diagnosis.

Taking the advice from their financial advisor, they transferred CLP shares from Irma’s account and the joint account into the account in Norman’s name only. When Norman passes, Irma will inherit the entire $1.5 million of CLP stock with a full step-up in basis to $1.5M.

Thus, a sale of the stock by Irma after Norman’s passing would have resulted in no capital gains, potentially saving Irma $100,000 or more in unnecessary taxes, and netting her the full $1.5 million proceeds.

Of course, like nearly everything tax-related, there are exceptions, ‘gotchas’ and contraindications to be aware of and to watch out for.

One-year holding period “boomerang” rule

One of the most critical issues to be aware of with this type of planning is the one-year holding rule that applies in certain situations, which can limit eligibility for a step-up in basis.

Specifically, under IRC Section 1014(e), if, within one year of a gift of assets, those assets pass back to the original donor (or the original donor’s spouse) on account of the donee’s death, there is no step-up in basis, and the original basis of the asset will continue to apply.

In essence, the rule prevents the exact scenario of everyone in the family gifting assets to someone who is about to pass away, only to receive them back shortly thereafter with a stepped-up basis (by imposing a 1-year waiting period instead).

Thus, while the strategy of transferring appreciated assets to a first-to-die spouse’s account can work well if there is enough lead time between planning and death, the strategy does not work well in situations where there is very little warning of an impending death, or when it comes as a surprise.

Example #8: Richard and Ester are married and live in a common law property state. Thirty years ago, and prior to getting married, Richard bought shares of Homerun stock for $25,000. Since then, Homerun has lived up to its name, and the stock is now worth $1 million.

Suppose that, for whatever reason, Richard never changed the ownership of his account and the stock is still held in his name only. Furthermore, suppose that Richard and Ester get some bad news — Ester is terminally ill.

Richard and Ester manage to take the steps necessary to open an account in Ester’s name and to transfer the Homerun stock to her account. If Ester manages to hold on for at least a year after the transfer, upon her passing she can bequeath the stock back to Richard, and he would be entitled to a full step-up in basis and could then sell the $1 million of Homerun stock tax-free.

Conversely, if Ester passes away within the one-year window, Richard will not receive a step-up in basis and instead, will simply carry over (or really, carry back) his original basis of $25,000. Thus, a future sale of the stock would result in a substantial amount of capital gains, but no worse than not having tried the strategy in the first place.

In times when bad news like this is received, the last thing that’s probably on anyone’s mind is tax planning, understandably so. But that’s one of the main reasons that couples like Richard and Ester might engage the help of a professional, to help them remove emotion from the equation and help them make sound financial decisions, even in the toughest of times.

Loss of control over gifted assets

It’s nice to think of a world where every couple gets along perfectly and is completely open, honest and transparent with one another at all times. Yes, it’s nice to think about but it’s not the world we (always) live in.

With that in mind, prior to engaging in a gift-and-get-back-after-death strategy, donors of such property living in common law property states should have a high level of trust in the receiving spouse that, upon their passing, they will actually complete the second half of the equation and leave the assets back to the initial-donor-surviving spouse. Because once the assets are transferred, there’s nothing to prevent the receiving spouse from leaving the assets to someone else (another family member, a friend or even a charity). Which means there’s a risk that the surviving spouse may end up with nothing.

Example #9: Charles and Karen are married and live in a common law property state. Many years ago, Karen inherited shares of JKL stock, which at the time was valued at $50,000 (her basis). Today, the stock is still owned in Karen’s name only, but has ballooned in value to $2 million.

Unfortunately, Charles has just been diagnosed with cancer, for which the typical prognosis is three to five years. Suppose that, in an effort to make the best of a bad situation, Karen transfers the shares of JKL to an account only in Charles’s name in order to try and get a step-up in basis upon his passing.

Fast-forward a year and half…

Having made it past the year mark, Charles can now leave the stock back to Karen, who would then receive a full step-up in basis. However, as Charles’s condition deteriorated, he was moved into an assisted living facility. While he was there, he fell in love with one of the nurses.

Sensing the end is near (but still of legally sound mind and body), Charles calls up his estate planning attorney and changes his will to leave all of his assets to his new-found love.

Once Karen has gifted the assets to Charles, they are his assets, and as such, she does not get a say to whom they are left. Thus, she may be largely, or even entirely, disinherited from her “own” assets.

Sketchy? Yes.

Morally repulsive? Yes.

But legal? You betcha!

Clearly, this result would present a problem for anyone in Karen’s shoes. And that’s why supreme trust between spouses is such an important element when engaging in this type of planning (and particularly in second marriage situations where it’s not uncommon for spouses not to leave assets to each other, and instead to bequest assets to children from their first marriages instead).

Transferring assets to potentially Medicaid-eligible spouses

An additional complication that individuals must be aware of is when the spouse who is likely to die first is also currently enrolled in Medicaid, or may otherwise be planning to apply for (and hoping to become eligible for) such benefits in the future.

Because, as most advisors are aware, Medicaid is a means-tested program and generally requires that individuals spend down their assets to extremely modest levels prior to being eligible to receive benefits under the program. And in such scenarios, transferring assets to a Medicaid beneficiary, or a potential Medicaid beneficiary, is almost never a good idea, as it can partially or fully disqualify them from Medicaid (and effectively force them to spend down the assets they just received, such that there may be little or nothing left to bequeath back at the end).

In fact, to the extent possible, assets should generally be transferred out of such persons’ estates, even if it means giving up tax benefits. After all, a step-up in basis isn’t worth much if there are no assets left to step-up (because Medicaid required them to be spent down first.)

Or viewed from the other side, it’s better to have some of the assets go to Uncle Sam in the form of taxes, than to have most or all of the assets consumed for medical expenses while waiting to qualify for Medicaid instead.

On the other hand, in many states, a “well spouse,” sometimes referred to as a “community spouse,” is only allowed to keep a certain moderate level of assets so as to avoid impoverishment themself, with the rest of the community spouse’s assets being spent down for care as well.

For 2022 this inflation-adjusted amount is capped at $137,400. Which means a couple with sizable assets — hoping to receive a step-up in basis — may be compelled to spend down at least most of the value of the assets waiting to qualify for Medicaid, even if it’s not transferred to the ill spouse and remains with the healthy spouse instead.

However, it’s also important to note that Medicaid is a federal-state partnership, and therefore the exact rules vary substantially from state to state. And in some states, there are additional options — such as “spousal refusals” — that allow a well spouse to keep more assets.

Alternatively, enrollment in a long-term-care partnership program may allow a Medicaid beneficiary to retain more assets without requiring them to be spent, which in turn (re)opens the door to transferring assets into that ill spouse’s name for cost basis step-up opportunities as well.

The bottom line: It’s important to be mindful of how Medicaid eligibility (or a desire to qualify for Medicaid in the foreseeable future) could impact the gift-and-get-back-after-death strategy. And that means having a sound understanding of the local state laws that factor into the equation.

An unfortunate part of reality is that, at some point, we will all come to the end of our time on Earth. It’s inevitable.

While repositioning assets in anticipation of an individual’s death may sound morbid — and probably is a bit morbid — it’s not going to change the reality of when that individual will die. A critical role of a good financial advisor is to help their clients remain objective and rational. And in the end, an objective and rational person will often wish to minimize the impact of taxes for a loved one, even if that means being forced to confront their own mortality.

For spouses in separate property states, that often means shifting appreciated assets into the name of the likely-to-die-first spouse’s name. Where appropriate, such transfers should be completed sooner, rather than later, to increase the odds of the ill-spouse surviving the year necessary to allow the survivor to enjoy the step-up in basis.

Director of Advanced Planning, Buckingham Wealth Partners