Suppose Don bought unimproved real estate 35 years ago for $100,000 and now it’s worth $550,000. Don’s tax basis is $100,000. If he sells the property at its current value, he will have a capital gain of $450,000, which will come with a fairly large income tax liability.
If Don makes an inter vivos (during life) gift of the property, whether in trust (with some exceptions, see below) or as an outright gift, he transfers his basis to the donee(s). Therefore, the donee will be subject to the same capital gains tax liability upon selling the property.
Don, now up in age, fears rumors about the pitfalls of probate proceedings. He tells his attorney to prepare a deed so he can give the property to his son now and avoid probate. When the deed is delivered, his son’s basis is $100,000. Don dies the following month. Don’s son then sells the property for $550,000 and incurs a $90,000 tax on the capital gain.
Instead, suppose Don’s attorney advises Don to hold on to the property until his death. Property which is held in the estate of a decedent receives a step up in basis equal to the property’s fair market value at the date of death. If Don leaves the property to his son upon his death, his son’s basis will be stepped up to $550,000 (its fair market value). If Don’s son sells for $550,000, there will be no gain for tax purposes. If Don’s son sells for $600,000, his capital gain will be $50,000 (resulting in a tax liability of only $10,000).
Want to help your children get the most out of your estate? For all but very wealthy people, the plan should be to die with it rather than give it away during life.
What about Trusts?
Caution should be exercised with trusts. In many scenarios, trusts are oversold by attorneys when there is no rational need for one. Simply “avoiding probate” is not a good enough reason.
There can be many good reasons for putting property into trusts. Common ones include caring for disabled children, protecting the property from creditors of the grantor’s beneficiaries, limiting access to beneficiaries who are poor money managers, and estate tax avoidance.
When the grantor contributes property to a trust, the IRS will still consider it as owned by the grantor (i.e., not a gift and therefore qualifying for the step up) in certain, limited situations – such as when the trust is revocable at the sole option of the grantor or when the grantor has a life estate in the income from the trust.
In addition, caution should be used when homesteads are held in a trust. (Read about this here.)