Tax Benefit of Complete Step-Up in Basis for Assets is Often Significant
In our post, 4 Key Benefits of a Revocable Trust, we discussed the benefits of placing your assets into a revocable trust before your death or potential incapacity. Revocable trusts provide numerous benefits not enjoyed by individuals whose estate plans involve the use of a Last Will and Testament (“Will”) alone.
Some Benefits of a Revocable Trust
(1) Simplified, Faster, and Less Expensive Distribution Process:
Assets held in a revocable trust are not subject to the probate process. Therefore, they can be distributed to your beneficiaries without court oversight, through a simplified process that is typically less expensive and time-consuming.
(2) Preservation of Family Privacy:
Because revocable trusts are not placed in the public record, the terms, including details about your family’s finances and the nature and location of your assets, remain private and confidential.
(3) Organization and Consistency:
The terms of the revocable trust serve as a “road map” for your trustee and/or their successors, who are in turn authorized to act for the benefit of your heirs without the need for judicial oversight, and who enjoy largely unrestricted and streamlined access to a portfolio of assets that have already been aligned, organized, and made easily locatable.
(4) Protection for your Descendants:
Finally, a revocable trust can include provisions establishing a dynasty trust (sometimes called a “bloodline trust”), which preserves your assets exclusively for the use and benefit of your children and grandchildren. Unlike the outright distributions provided to children or grandchildren in a Will, distributing these assets through a dynasty trust prevents the funds from being intermingled with your child’s or grandchild’s personal funds, and potentially becoming exposed to the risk of loss through the claims of a divorcing spouse or creditor.
In short, a revocable trust provides you with more control and strategy over your assets, and a greater ability to protect your descendants, than is possible through the use of a Will alone.
The Case For Separate Revocable Trusts
Most married couples who include a revocable trust in their estate plans choose to form one trust, commonly referred to as a “joint revocable trust.” Because this arrangement allows all assets of the couple to be intermingled and easily managed by both individuals, it is understandably viewed as an appealing and straightforward option. However, substantial additional benefits can be achieved through the often-overlooked option of creating a separate revocable trust for each spouse. While this arrangement does require the assets of the couple to be divided between the two trusts, typically with the help of an experienced financial advisor, it is our experience that the eventual tax benefits of separate trusts outweigh the minor inconvenience of separate accounting.
Perhaps the most significant benefit of separate revocable trusts is the availability of a complete step-up in tax basis for the assets allocated to the trust of the first spouse to pass away. At the time of the first spouse’s death, any trust assets of the deceased spouse that have capital gains tax treatment will have a step-up in basis when transferring to the trust of the surviving spouse, and will be valued at their fair market value as of the date of death. Because the stepped-up basis is typically higher than the assets’ value at the time they were originally acquired, and because any subsequent increase in the value of the assets will be measured, for income tax purposes, against the new step-up value, this can result in significant income tax savings when the surviving spouse eventually sells, liquidates, or otherwise transfers the assets.
Complete Step-Up vs. Half Step-Up in Basis
This ability to step-up the basis on inherited assets can be applied to invested assets as well as any asset that appreciates over time. For instance, a house purchased for $150,000 in 1995 may double in value before the death of the first spouse. If that house is placed into a separate trust, the surviving spouse can eventually sell the house and only pay capital gains tax on the difference between the stepped-up basis and the sale price of the house, which presumably will be a lot less than the difference between the home’s original purchase price and the stepped-up basis (the value of the house at the time of the first spouse’s passing).
Step-up in basis is also available to married couples with a joint revocable trust, but the tax savings are smaller. Assets held in a joint revocable trust are considered to be equally owned by the two spouses as joint grantors of the joint revocable trust, but at the time of the first spouse’s death, only his or her 50% share is stepped-up in basis. When the surviving spouse dies, their remaining assets are measured and evaluated at a half-stepped up basis position. Therefore, a tax benefit is still realized, but it is only half the value when compared to the separate revocable trust strategy.