One of the most valuable yet often overlooked tax benefits in estate planning is the “step-up in basis.” In California, where property values are often high and many residents use living trusts to manage and transfer their assets, understanding how the step-up in basis works – and how it interacts with a living trust – is crucial to maximizing tax efficiency for heirs.
“Basis” refers to the value of an asset for tax purposes, typically the original purchase price, adjusted for improvements or depreciation. When someone sells an asset, such as real estate or stocks, the capital gains tax is calculated based on the difference between the sale price and the basis.
A “step-up in basis” occurs when a person inherits an asset upon the owner’s death. Instead of inheriting the original basis, the heir receives the asset with a new basis equal to its fair market value at the date of death. This means that if the asset is sold shortly after being inherited, the capital gains tax may be minimal or nonexistent, because the gain is calculated from the date-of-death value rather than the original purchase price.
In California, a living trust (also known as a revocable trust) is a popular estate planning tool. It allows an individual (the “trustor” or “grantor”) to place assets into a trust during their lifetime and designate beneficiaries to receive those assets upon death, all without going through probate.
Because a revocable living trust does not create a separate tax entity during the trustor’s lifetime, the trustor continues to be treated as the owner of the assets for tax purposes. However, upon the trustor’s death, the trust becomes irrevocable, and the trust assets are distributed according to the terms of the trust agreement.
Importantly, assets held in a revocable living trust are eligible for a step-up in basis at the time of the trustor’s death, just as if they were owned outright by the decedent. The key is that the trust must be revocable during the owner’s lifetime, and the assets must be included in the decedent’s estate for federal tax purposes.
For married couples in California, a community property state, there’s an additional advantage: If community property is properly characterized and held in a revocable living trust, both spouses’ halves of the property receive a full step-up in basis when the first spouse dies. This means the surviving spouse can sell the property with little or no capital gains tax.
Failing to understand or properly plan for the step-up in basis can result in unnecessary capital gains taxes for heirs. It’s also important to ensure that assets intended to benefit from the step-up are properly titled in the trust. Estate planning attorneys and tax advisors can work together to ensure that both the estate plan and the tax strategy are aligned. Proper planning ensures that this key tax advantage is not lost.
Send your questions to ccolan@colanlegal.com and use “Alpine Mountaineer estate planning question” as the subject. We’ll answer your questions in our upcoming issues. This article is provided by your local estate planning attorney, Corina Colan. The Law Office of Corina I. Colan / (909) 265-3315 / www.colanlegal.com
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