Tax Legislation Doubling the Federal Estate Tax Exclusion Opens Door for Important Capital Gains Tax Planning in Living Trusts for Married Couples
by Angela Kil, Esq.
An important federal tax law that took effect on January 1, 2018 that increased the estate tax exclusion from $5,490,000 in 2017 to $11,180,000 in 2018 for each taxpayer (now $11,400,000 in 2019). Under the new law, in 2019, married couples can now shelter a combined inflation adjusted $22,800,000 from estate tax using both spouse’s exclusions. However, the increase to $11,400,000 per spouse may be temporary in the absence of new legislation. As written the law “sunsets” on December 31, 2025 reverting to the prior exclusion, which would then be in the neighborhood of $5,000,000 to $6,000,000 per spouse.
The 2018 exclusion increase, in combination with other recent legislation and IRS rule changes, opens the door for some easy-to-implement capital gains tax planning for married couples that could save their beneficiaries hundreds of thousands tax dollars.
Who Can Benefit from the Planning?
Married couples with revocable trusts (commonly referred to as living trusts) and less than $22,800,000 in total assets could benefit from this planning. After 2025, even if the current law does sunset, then married couples with revocable trusts with less than $11,400,000 in assets can still benefit from this planning.
This planning is simple to implement. Replace the more traditional Exemption Trust (also known as Bypass Trust, Credit Shelter Trusts or “B” Trust ) established in your existing revocable Trust on the first death to hold the deceased spouse’s assets with a different Trust that qualifies for the marital deduction, often referred to as a Marital Deduction Trust, QTIP Trust or “C” Trust. Doing so can wipe out most, if not all, of the capital gain tax that would otherwise be owed upon the sale of appreciated assets following the death of the second spouse. Depending on how much the assets have appreciated between the deaths of the first and second spouse, the capital gain tax savings could be substantial.
How does it work?
Specifically, this new planning involves revising your revocable Trust to create a Marital Deduction Trust instead of an Exemption Trust upon the death of the first spouse. Assets in the Marital Deduction Trust are “included” for estate tax purposes in the estate of the second spouse upon his or her later death. Assets in the Exemption Trust are not “included” in the surviving spouse’s estate. Assets which are included in the surviving spouse’s estate receive a new “stepped-up” cost basis equal to their then fair market value on the date of the surviving spouse’s death.
Previously, when the estate tax exclusion was anywhere from $600,000 to $1,000,000 (instead of $11,400,000 now) and the estate tax rate was as high as 55% (instead of 40% now), the planning focus was to draft Trusts to exclude assets from the surviving spouse’s estate to avoid the estate tax. Now, with the much higher estate tax exclusion and lower estate tax rate, the better practice for married couples with estates under $22,800,000 is often to deliberately design the Trust include assets in the surviving spouse’s estate for the potential capital gains savings.
Illustration of Tax Savings from Marital Deduction Trust Model
The easiest way to understand how to maximize this capital gains tax planning is through an example. Assume the following for illustration purposes:
A married couple, John and Jane Smith, have no separate property, and community property trust assets worth $6,000,000 in June of 2020 when John dies at age 81. Their current Trust divides the into two Trusts as a result of John’s death, an Exemption Trust holding John’s 50% of the assets ($3,000,000) and a Survivor’s Trust holding Jane’s 50% of the assets ($3,000,000). Jane lives off the assets in the Survivor’s Trust and invests the Exemption Trust for growth. Jane later dies in 2035 at age of 93. By the time of Jane’s death in 2035, the assets in the Exemption Trust have grown in value to $6,000,000 and the assets in the Survivor’s Trust have grown in value to $4,000,000. Following Jane’s death, the Trustee sells the assets in both Trust in preparation for distributing equal shares of cash to their three adult children, James, Judy and Jenny.
Under a traditional Exemption Trust model, when John dies in 2020, the community property assets allocated to the Exemption Trust receive a new basis (known as a “step up” in basis) of $3,000,000 equal to their fair market value. Similarly, the Survivor’s Trust assets also receive a new cost basis of $3,000,000 in 2020 equal to their fair market value. When Jane dies in 2035, only the Survivor’s Trust assets receive another adjustment in basis to $4,000,000 equal to their 2035 fair market value. However, because assets in the Exemption Trust are not included in Jane’s estate, the basis remains at $3,000,000 in 2035. The sale of the Survivor’s Trust assets following Jane’s death in 2035 at their fair market values generates no capital gain since the sales price and the basis are the same. However, the sale of the Exemption Trust assets following Jane’s death in 2035 for $6,000,000 generates a capital gain of $3,000,000, being the difference between the $6,000,000 sales price and the $3,000,000 basis. The combined federal and state income tax owed by the Exemption Trust or its beneficiaries on the capital gain would be in the range of $900,000.
Under the recommended Marital Deduction Trust model, when John dies in 2020, the community property assets are instead allocated to the Marital Deduction Trust and still receive a new basis of $3,000,000 equal to their fair market value. As with the other model, the Survivor’s Trust assets also receive a new cost basis of $3,000,000 in 2020 equal to their fair market value. When Jane dies in 2035, the Survivor’s Trust assets again receive another step up in basis to $4,000,000 to equal their 2035 fair market value. However, in contrast to the Exemption Trust model, under the new Marital Deduction Trust model the assets in the Marital Deduction Trust are included in Jane’s estate and the basis is also increased – to $6,000,000, equal the 2035 fair market value. The sale of the Survivor’s Trust assets following Jane’s death in 2035 at the fair market values again generates no capital gain since the sales price and the basis are the same. Now, the sale of the Marital Deduction Trust assets following Jane’s death in 2035 at the fair market value also generates no capital gain since the sales price and the basis are the same. In the absence of taxable capital gain, there are no income taxes owed under the Marital Deduction Trust model on the liquidation, but also no estate tax as the total assets ($10,000,000) is below the combined estate tax exemptions of John and Jane.
In this illustration, the Marital Deduction Trust model saves the children in the range of $900,000 in (capital gain/income) tax in comparison to the Exemption Trust model.
What is the Next Step?
If you are married, if your combined estate with your spouse is under $22,800,000 and if you believe that your Trust currently contains an Exemption Trust (also known as a Bypass Trust, Credit Shelter Trust or “B” Trust), e-mail or call any of our four estate planning attorneys. We are glad to take a look at your current Trust instrument and let you know if additional revisions to your Trust can help your beneficiaries avoid having to pay unnecessary taxes following your deaths.
Our phone number is 310-545-0010.
You can also e-mail us at:
Angela Kil: firstname.lastname@example.org
Bruce Macdonald: email@example.com
Chris Carico: firstname.lastname@example.org
Taylor Carico: email@example.com
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