Preserving the Step Up in Basis at Death of Second Spouse

The income tax concept of “basis” figures prominently in
estate planning. On the sale (or final disposition) of an asset, the seller’s basis
is used to calculate whether the seller has a gain or loss for income taxes.     A
capital gains tax occurs when an asset is sold or more than its basis; such as
when an appreciated asset is sold or when a depreciated asset is sold (or
disposed of) for more than its remaining tax basis.  Minimizing these capital gains taxes is an
important estate planning goal.

How basis is determined varies as follows: (1) Purchased
assets have an initial cost (purchase price) basis; which may get adjusted up
for capital improvements and down for income tax depreciation; (2) Gifted
assets carry over the transferor’s basis; and (3) Inherited assets, other than
retirement assets, receive a new basis equal to the appraised date of death
value (if higher, it is called a “stepped-up” basis) because they were included
in the deceased person’s estate for federal Estate Tax purposes, regardless of
whether an Estate Tax was due. 

With the Estate Tax thresholds now at $5,250,000 and
$10,500,000 for single and married persons, respectively, the Estate Tax rarely
ever bites but is always relevant for basis purposes (except for retirement
assets).

            For example, in 1970 a father buys his
home for $50,000; the father’s initial basis is $50,000.  In, 1975, the father makes $20,000 in
improvements.  He gets a new basis of
$70,000.  In 2012, he dies and his
daughter inherits the home, now appraised at $250,000.  Daughter’s new basis is $250,000; a $180,000
increase.

            Married couples have tax
opportunities both for the surviving spouse and for the couple’s subsequent
beneficiaries.   At the first spouse’s death, the deceased
spouse’s separate property and all the couple’s community property assets get a
new basis.  All assets owned as community
property receive a full basis adjustment (even though half belongs to the
surviving spouse). 

At the second spouse’s death, the first deceased spouse’s separate
property assets may sometimes get a second step up in basis that typically
benefits the children.  That is, provided
such assets are includable in the second spouse’s estate for federal Estate Tax
purposes.  That can be either because
these assets were gifted directly to the surviving spouse (either outright or
to the surviving spouse’s revocable trust) or because the decedent’s assets
were held in a further Marital Trust.

A Marital Trust, to qualify as such, must provide that the
surviving spouse receives all the income from the assets, during her lifetime.  It may also provide for distributions of
principal to the surviving spouse. While alive, the surviving spouse must be the
sole beneficiary.   At her death, the remaining
assets typically pass to the first spouse’s children.  

 Irrevocable trusts that
were previously established at the death of the first spouse with the deceased
spouse’s assets, as so-called Bypass (aka, “Credit Shelter”) Trust may
sometimes qualify as Marital Trusts.  If
the irrevocable trust satisfies the requirements to be a Marital Trust, a
special so-called QTIP election can be made (this year) to allow the trust
assets to be included in the surviving spouse’s estate for Estate Tax purposes
and to get a new (and hopefully higher) basis at the surviving spouse’s death.

For these reasons, many estate planners now draft any
irrevocable trust established at the death of the first spouse to meet the
Marital Trust requirements.  The
surviving spouse can then make the QTIP election, presuming the surviving
spouse’s enlarged estate is not expected to be so large as to suffer from an
Estate Tax that would exceed the income tax benefits.