Tax planning is becoming the new wealth transfer planning. Learn how basis planning may help lower capital gains taxes on the assets you leave to your heirs—ultimately making it possible for them to enjoy more of their inheritance.

“Till death do us part,” is beginning to take on a whole new meaning now that the estate tax exemption has effectively doubled. It may now make more sense to pass on certain assets after you die rather than gifting or selling them in your lifetime. Doing this may enable your heirs to enjoy more of the inheritance you have for them.

A type of planning referred to as basis planning largely applies to assets that have appreciated significantly since they were acquired. Basis planning helps mitigate capital gains taxes, which are levied on the sale of an asset.

This type of planning is becoming more of a focus for those seeking to transfer wealth to heirs who are then likely to sell the assets. 

The higher estate tax exemption means many family fortunes will no longer be subject to estate taxes. These families may now structure wealth plans to pass on more assets at death as part of their estate. By including highly appreciated assets in their estate plan, they can help mitigate capital gains taxes when those assets are sold. The Tax Cuts and Jobs Act of 2017 raised the total amount that may be transferred during your lifetime as a gift, or after you die as part of your estate, to $11.7 million for individuals and $23.4 million for couples in 2021, which amount is scheduled to be indexed for inflation through 2025.

Basis Planning Basics

Cost basis is the price of an asset that is used to calculate capital gains or losses. The Internal Revenue Service (IRS) allows the cost basis of most assets included in an individual’s taxable estate to be adjusted to fair market value on the date of death.[1] This adjustment eliminates all unrealized gains prior to death and therefore any capital gains taxes upon sale on the appreciation of the asset to that date of death. 

  • Capital gains taxes are applied to capital gain income.
  • Capital gain income = sales price – cost basis.

There are a number of strategies that incorporate basis planning. Below we review some of the more common types. 

Deciding whether these strategies are right for your individual situation is complicated. Lack of an estate tax does not necessarily preclude making gifts during your lifetime, nor does saving on capital gains taxes always equate to implementing a basis-planning strategy. We recommend you speak with your tax and legal advisors to discuss how each of these may affect you and your planning.

Example 1: Basis Planning

The Asset: 1,000 shares of a stock currently trading at $100 a share

The Purchase Price: Bought by Amanda 30 years ago at $1 a share[2].

Situation 1: Amanda sells the stock today.

Outcome 1: Amanda recognizes capital gains of $99,000 ($100 - $1 cost basis x 1,000 shares) and incurs a federal capital gains tax of $19,800.[3]

Situation 2: Amanda gifts the shares to her children, Jeremy and Sarah, in her lifetime. The shares do not benefit from the basis step-up and retain Amanda’s original $1 per share cost basis.[4] Jeremy then sells his 500 shares at $100 a share and Sarah holds her shares for six years and then sells them at $150 a share.

Outcome 2: Jeremy incurs $9,900 in federal capital gains tax on $49,500 in gains ($100 - $1 cost basis x 500 shares) and Sarah incurs $14,900 in federal capital gains tax on $74,500 in gains ($150 - $1 cost basis x 500 shares).

Situation 3: Amanda leaves in her will 500 shares each to Jeremy and Sarah. The cost basis steps up to $100. Jeremy then sells his 500 shares at $100 a share and Sarah holds her shares for six years and then sells them at $150 a share.

Outcome 3: Jeremy incurs no federal capital gains tax ($100 - $100 cost basis x 500 shares) and Sarah incurs $5,000 in federal capital gains tax on $25,000 in gains ($150 - $100 x 500 shares).

Spousal Planning

Most couples will plan to leave some, if not all, of their assets to their surviving spouse. Their paramount concern is the welfare of their husband or wife. In addition to the emotional benefits, there are tax and basis planning benefits to this course as well.

Outright Bequests: Many people plan to leave their wealth through an outright bequest to their spouse. And most know they can do so without incurring estate tax.[5] What they may not know is that assets left outright may receive a partial or full step-up in basis. This means if you receive, for example, stock or a home that has appreciated, you may sell it during your lifetime with the cost basis adjusted to the higher value.[6]

  • Planning Point: Even if the estate tax does not apply, it is a best practice to document the value of assets to support the higher cost basis when the asset is sold. This may be as simple as an investment statement showing securities held on the date of death. Other assets may require additional documentation. 

Marital Trusts: Creditor protection and the peace of mind that comes with knowing your assets will pass to your children after the death of your surviving spouse are some reasons why couples often set up marital trusts. They also allow for a double step-up in basis—once upon the death of a spouse and again at the death of the surviving spouse. 

  • Planning Point: For those with marital trusts, it may be worth considering including highly appreciated assets. It is important to note that because the assets are held in trust and not owned outright, depending on how the trust is set up, the surviving spouse may be limited when it comes to drawing on the principal. 

Swap Powers 

One of the most commonly used trusts is a grantor trust. Assets in grantor trust do not, however, step up in basis upon the death of the person who set up the trust, known as the grantor. This is because the assets put in such a trust are considered lifetime gifts. This means if an asset in a grantor trust appreciates, the beneficiary who receives it will need to pay capital gains tax based on the value of the asset when it was purchased by the grantor. That could result in a significant tax. There is, however, a way to mitigate this: swap powers.

A swap power enables the grantor to substitute trust assets with assets of equivalent value.[7] The asset that is swapped out of the trust can then be left as part of the estate. 

This would qualify the asset for a step-up in basis, alleviating some capital gains tax burden. Cash or high-basis assets are often used to swap out the highly appreciated asset. This strategy works with most assets, but assets with readily ascertainable values, such as publicly traded stocks and bonds, work best. Using assets that do not have an easily recognized fair market value may cause unwanted scrutiny.

  • Planning Point: It may be worth exploring with your advisor if you have assets that would benefit your wealth plan by being swapped out of a grantor trust.
  • Planning Point: If you’ve already established one or more trusts that do not have swap powers, a trust modification may enable the trust to add them. If modifications are not deemed advisable, another option may be to decant the trust. Decanting is a process whereby the assets of one trust are distributed to another, much like wine is decanted from one container to another. Decanting and modifications are ways to adjust a trust instrument to account for unforeseen changes in circumstances, to carry out the grantor’s intent, or if the modification is in the best interest of the beneficiaries. Decanting and modifications are legal procedures and should be handled by your legal advisor.

Example 2: Swapping Appreciated Assets

Katy sets up a grantor trust that includes swap powers for her daughter Fran. Katy gifts to the trust 1,000 shares of stock A that she purchased at $10 a share, for a total value of $10,000. The stock appreciates to $100 a share, or total value of $100,000. Katy’s estate in 2021 is under $11.7 million and so is not subject to estate tax.

Situation 1: Katy leaves the shares in the grantor trust.

Outcome 1: Fran inherits them at a cost basis of $10 a share. If Fran then sold the stock, she would pay capital gains tax on $90 a share, or $90,000 in total, resulting in a federal capital gains tax of $18,000.[8]

Situation 2: Katy exercises the trust’s swap powers and swaps out the shares with $100,000 in cash.

Outcome 2: Upon Katy’s death, Fran inherits the $100,000 in cash along with other assets in the trust. She also inherits, as part of Katy’s estate, the shares of stock A. The stock is passed through the estate and steps up in value to $100 a share. Fran sells the $100,000 of stock at $100 a share and pays no capital gains tax on it.

Four Ways to Mitigate Capital Gains

To the extent that your overall planning goals are met and it is allowed:

  • Weigh appreciation potential when choosing which assets to gift.
  • Consider moving highly appreciated assets out of trusts and into your estate.
  • Make use of the unlimited marital deduction by leaving as much to your spouse as possible.
  • Consider creating or modifying trusts to grant General Powers of Appointment.

Most Beneficial for Basis Planning (versus Lifetime Gifting)

When families seek to transfer assets to heirs, they typically do so by making gifts during their lifetime or passing them after death as bequests. In general, certain assets benefit more from basis planning, which applies only to assets that transfer through an estate, as opposed to a lifetime gift.

  • Creator-owned intellectual property, intangible assets and artwork
  • Negative Basis Assets (commercial property and/or limited partnership interests)
  • Investor/Collector owned artwork, gold, or other collectibles
  • Low basis stock or other capital asset
  • Qualified Small Business Stock
  • High Basis Stock

Least Beneficial (versus Lifetime Gifting)

  • Cash 
  • Stock or other capital assets with unrealized losses
  • Traditional IRA or Qualified Assets (Income in Respect of a Decedent)

General Powers of Appointment 

Many trusts do not terminate when the grantor passes. They keep assets in trust for the life of the beneficiaries and sometimes beyond. It is not uncommon for these trusts to have highly appreciated assets in them. It is not, however, possible to swap assets out of a trust once the grantor passes. Only a grantor has that ability, provided the trust allows for it.

As long as the assets stay in trust until the death of the beneficiary, there is a way to have them step up in basis—by granting general powers of appointment (GPOA) to the beneficiary. This will help mitigate capital gains taxes in both cases: if the heirs of the beneficiary receive the assets and then sell them, or if the assets remain in trust and the trust sells them. 

Example 3: General Powers of Appointment

Robert sets up a trust for his son, Alex, and his grandson, Benjamin. The trust will terminate at Alex’s death and distribute the assets to Benjamin. The trust is funded with $3 million in securities with a cost basis of $1 million (meaning Robert purchased the securities for $1 million). At Alex’s death, the trust is valued at $5 million. Alex’s total estate is valued at $2 million, not including the $5 million trust value. The estate exemption in 2021 is $11.7 million, so the estate is not subject to estate tax.

Situation 1: Alex is not granted GPOA.

Outcome 1: The trust terminates and Benjamin receives assets valued at $5 million with a cost basis of $1 million. Benjamin sells the assets and recognizes capital gains of $4 million and incurs a federal capital gains tax of $800,000.[9]

Situation 2: Alex is granted a GPOA over the trust assets.

Outcome 2: The $5 million in securities receives a step-up in cost basis to $5 million. Regardless of whether the trust terminates and Benjamin sells the $5 million in securities or if they remain in trust and the trust sells the securities, no capital gains tax will result and no estate tax will be due because there is sufficient estate exemption.

Situation 3: Assume the same facts as situation 2 above, except Alex’s estate, not including the $5 million in securities in the trust, is valued at $10 million. Granting Alex a GPOA over all trust assets would result in imposition of an estate tax if Alex died in 2021. This is because his estate value would rise to $15 million and the estate tax exemption is $11.7 million. Estate values and estate tax exemptions can change over time. GPOA can be granted to account for this. For example, Alex could receive GPOA on $1.7 million of the securities, leaving Benjamin with no capital gains tax on that portion of the securities. Estate taxes are almost always higher than capital gains taxes.

Granting GPOA is a widely used way to add flexibility to trust planning. It will cause the assets covered under the GPOA to be included in the beneficiary’s estate, regardless of whether the power is exercised or not.[10] And it can be structured to provide a basis step-up for some or all trust assets while avoiding the risk of incurring estate tax.[11]

  • Planning Point: GPOAs give control of the asset to the power holder. They can be structured to limit risk that assets might pass in a manner that does not match the grantor’s intent.
  • Planning Point: To avoid granting a general power to a beneficiary when it is not necessary or desired, it may be preferable that the power is granted by a trust protector or the trustee, rather than written into the trust agreement. 

A dollar of tax will cost a dollar whether paid as estate or income tax. Now that many people no longer have to worry about estate taxes, minimizing income taxes is becoming a focus. Basis planning is one way to do that.