Managing your taxes can be one of the most complex aspects of estate planning and a new IRS rule change continues that trend. The rule, published at the end of March, changes how the step-up in basis applies to assets held in an irrevocable trust. If you need help interpreting the IRS rule change or setting up your estate, consider speaking with a financial advisor.
When someone inherits an asset with unrealized capital gains, the basis of the asset resets or “steps up,” to the current fair market value, wiping out any tax liability for the previously unrealized capital gains.
For example, if you purchased stock for $100,000 more than a year ago and sold it now for $250,000, you would pay capital gains tax on the $150,000 profit above the original basis of $100,000. If you inherit that stock, however, your new basis steps up to $250,000 and you’ll pay tax only if you sell the stock for more than that amount.
To protect their assets, many people place them in an irrevocable trust, which means they lose all ownership rights to the assets. Instead, the trust becomes the owner of the assets for the benefit of the trust’s beneficiaries.
Previously, the IRS granted the step-up in basis for assets in an irrevocable trust but the new ruling – Rev. Rul. 2023-2 – changes that. Unless the assets are included in the taxable estate of the original owner (or “grantor”), the basis doesn’t reset. To get the step-up in basis, the assets in the irrevocable trust now must be included in the taxable estate at the time of the grantor’s death.
That’s the bad news.
The good news is that because of the $12.92 million per-person exclusion in 2023 ($25.84 million for married couples), few estates in the United States pay even a portion of the estate tax.
In 2021, 6,158 estates were required to file estate tax returns, with just 2,584 of them (42%) paying any tax at all. By including the irrevocable trust assets in the taxable estate, heirs who are the beneficiaries of the trust will dodge the tax hit and receive the step-up in basis. However, that situation could change for some people in 2026 when the estate tax exemption limit reverts to the 2017 amount of $5 million, adjusted for inflation.
Why would someone be using an irrevocable trust? A typical reason is to remove assets from your ownership in order to qualify for Medicaid nursing home assistance. A parent could place a home worth $500,000 into the trust, qualify for Medicaid but, by including the home in their taxable estate, then pass the property on to their children tax-free at a basis of $500,000.
Anyone using an irrevocable trust should be reviewing their estate plan to make sure it complies with the updated IRS rule and preserve the step-up in basis for assets that the trust will pass on to their heirs. Building a sufficient estate plan is also something that most people should try to have in place in order to limit issues for their family down the road.
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