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Estate planning has always been a complex task, and the recent IRS rule change, published at the end of March, adds a new layer of complexity. This rule adjustment redefines how the step-up in basis applies to assets held within an irrevocable trust, impacting individuals’ tax strategies when it comes to estate planning.
Understanding the Step-Up in Basis
The step-up in basis is a fundamental concept in estate planning. When someone inherits an asset with unrealized capital gains, the basis of that asset is reset or “steps up” to its current fair market value. This essentially erases any tax liability associated with the previously unrealized capital gains.
To illustrate, consider the scenario where you initially purchased stock for $100,000 over a year ago, and its current value stands at $250,000. In the event of a sale, you would owe capital gains tax on the $150,000 profit above the original $100,000 basis. However, if you inherit this stock, the new basis steps up to the current market value of $250,000, and you would only incur taxes if you sell the stock for more than this amount.
Many individuals opt to safeguard their assets by placing them in an irrevocable trust. By doing so, they relinquish ownership rights to the assets, which are then managed for the benefit of the trust’s beneficiaries.
Impact of the IRS Rule Change on Irrevocable Trusts
Until the IRS’s recent ruling, assets held within an irrevocable trust were eligible for the step-up in basis. However, the new directive, referred to as Rev. Rul. 2023-2, introduces a significant change. Now, unless the assets are included in the taxable estate of the original owner or “grantor,” the basis does not reset. To secure the step-up in basis for assets within an irrevocable trust, these assets must be incorporated into the taxable estate at the time of the grantor’s death.
The implication of this change is that heirs, who are the beneficiaries of the trust, can circumvent the tax implications and obtain the step-up in basis. It’s noteworthy that, due to the generous $12.92 million per-person exclusion in 2023 ($25.84 million for married couples), very few U.S. estates are subject to estate tax. In 2021, only 42% of the 6,158 estates required to file estate tax returns actually paid any tax.
Nonetheless, for some individuals, especially in 2026 when the estate tax exemption limit reverts to the 2017 amount of $5 million adjusted for inflation, this situation may change.
Irrevocable trusts are often employed for various purposes, such as qualifying for Medicaid nursing home assistance. For example, a parent might place a home worth $500,000 into the trust to become eligible for Medicaid. Then, by including the home in their taxable estate, they can pass the property tax-free to their children with a basis of $500,000.
Bottom Line: Navigating the IRS Rule Change
Individuals utilizing irrevocable trusts should reassess their estate plans to ensure compliance with the revised IRS rule. By doing so, they can preserve the step-up in basis for assets earmarked for their heirs. Creating a comprehensive estate plan is advisable for most people, as it can help mitigate potential issues for their families in the future.
Financial Planning Tips:
- Seek the guidance of a financial advisor to comprehend the implications of rule changes and keep your financial plan aligned with your goals.
- Life insurance plays a crucial role in financial planning, ensuring your loved ones are safeguarded in the event of unforeseen circumstances. Utilize SmartAsset’s life insurance tool to determine your optimal coverage level.
