Due to the nature of our business, one of the unfortunate things we sometimes must help our clients with is settling an estate following the death of a spouse. Handling a spouse’s affairs following death isn’t an easy thing, and tax laws can make it that much more complicated.
One thing that many people find confusing is the step up in basis and how it applies in evaluating the size of an estate. While the step up in basis is confusing, it’s actually a good thing. It can be used to reduce the capital gains tax you’ll pay on the sale of an appreciating asset and can help reduce your overall estate tax for heirs later on.
What Is a Step Up in Basis for a Spousal Inheritance?
Generally, spouses own property, bank accounts, and most other assets together. As a result, when one spouse passes away, full ownership is given to the surviving spouse. Often, that spouse will elect to defer paying estate taxes by claiming the deceased spouse’s exclusion and adding it to his or her own. It can then be used when the second spouse passes away, allowing heirs to take the full exemption amount of $22.4 million.
However, there are other tactics that the spouse can use to reduce the size of the estate even more so that heirs won’t eventually be hit with a major burden. The step up in basis allows a spouse to get some highly appreciated assets out of the estate while paying minimal capital gains taxes. This applies to assets that appreciate rapidly, like stock or real estate.
What happens is the value of the asset is reevaluated on inheritance. So, say the first spouse passes away and the jointly owned vacation home passes on to the living spouse. When they bought the home, they paid $500,000, but when the first spouse dies, the house has appreciated in value to $1 million.
If both spouses were still alive, and they simply owned the home and decided to sell it, they’d have to pay capital gains tax on that $500,000 appreciation. However, because the property is inherited, its value is reset to the fair market value, i.e. $1 million. So now, when the surviving spouse sells the property, he or she is only taxed on the difference between the fair market value and what the house is sold for. So, if the home sells for $1.1 million, the surviving spouse is taxed only on the $100,000.
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Keep in mind this calculation only applies to community property states. In these states, property acquired during a marriage is owned jointly. These states include:
- Arizona
- California
- Idaho
- Louisiana
- Nevada
- New Mexico
- Washington
- Texas
- Wisconsin
For any other state, you can only apply the step up to half the property because the deceased spouse only owned half the property. So, consider the case of the $500,000 home that appreciated to $1 million. When the first spouse dies, that spouse’s original interest in the property is calculated at $250,000 (one-half of the purchase price) and that interest is stepped up to $500,000. The second spouse’s new market value is his or her original purchase ownership value of $250,000 plus the inherited stepped-up value of $500,000. This means that the new basis of the home is $750,000 and only gains over $750,000 are considered taxable.
Either way, the step-up in basis is still a very valuable option because it can get highly appreciating assets out of your estate while eliminating a loss from capital gains taxes. But now that the home’s been sold, leaving the money in your estate could cause problems for your heirs when it comes time to settle it. In this case, you may want to use the funds earned from the sale to purchase life insurance policies to be held in an irrevocable life insurance trust (ILIT).
Using Sales Proceeds to Fund an ILIT
If you’ve decided to sell assets following the death of a spouse, you’ll likely want to do something to get those funds outside of your estate so your heirs won’t be hit with estate taxes. In this case, you can take the proceeds from the sale and use them to fund life insurance policies.
This works by leveraging your annual gift tax exclusion of $15,000 per person per year. While you’re capped at $15,000 per person, there’s no cap on how many people you can gift that amount. Say you’ve made $500,000 on the proceeds of a home and you have four children. Using a trust, you would make a yearly gift of $15,000 per child, for a total of $60,000 per year, to the ILIT. Those funds would be used to purchase life insurance policies on an annual basis, allowing you to whittle down the cash value of your estate. As the funds are gifted to a trust, they are removed from your estate and are not considered taxable at the time of your death.
Combining the step up in basis with an ILIT is a good way to slowly reduce the size of your estate, while also helping you avoid paying capital gains taxes during your lifetime. This is one of the tactics we employ while helping clients manage their estates through life insurance and trusts. For more information on how you can discount estate tax costs up to 90%, contact a Howard Kaye advisor today at 800-DIE-RICH.
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