Recent legislation was going to reduced estate tax exemption for 2022, however, insufficient support is leaving taxpayers with an exemption of $12,060,000 per person. This means that most taxpayers will not be subject to a Federal Estate taxes.
That leads us to focusing on income taxes for you and your family to look at and possibly minimize.
Enter the step-up in basis at death for assets. This can be a powerful planning tool for minimizing 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 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. This is often utilized with passing assets to children. The concept is fairly straightforward for assets owned solely by the decedent and passing to a child. It can become more complicated when the assets are owned jointly with a spouse (or even passing between spouses).
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, nine “community property” states allow for a 100% step-up in basis on all jointly-held assets.
- Arizona
- California
- Idaho
- Louisiana
- Nevada
- New Mexico
- Texas
- Washington
- Wisconsin
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.
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).
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 with a little planning.
