As we all know, capital gain is derived from the appreciation of assets. All of us hope our homes and other property increases in value after purchase. This appreciation results in capital gain. When we sell appreciated assets, there are tax ramifications which is called capital gains tax. Although the tax rate is considerably less than the income tax rate, it is still a tax. It diminishes that amount we can put in our pockets.
So, how can we reduce or negate capital gains tax in our Trust estate. First of all, spouses should sign a Community Property Agreement which lists all of the assets acquired during the marriage. Based on IRS Publication 555 (January 2013) and Publication 551 (July 2011), assets titled as community property receive a 100% step-up in basis which negates all of the capital gain in such assets.
For example, if a rental property purchased for $500,000, the cost basis is normally the purchase price. If the property appreciates in value to $1 million at the death of the first spouse, we have a capital gain of $500,000. Hopefully the property has been transferred to the Family Trust as community property. I always list real property transferred to the Trust as community property on the deed unless it is claimed as separate property by a spouse. Once it is transferred to the Family A-B Trust as community property, the surviving spouse obtains a 100% step-up in basis to fair market value as of the date of death of the first spouse. This totally eliminates the capital gain. Thus, in our example, the surviving spouse could have sold the rental property for $1 million and paid zero capital gains tax.
Continuing our example, let's say that the couple had a total of $4 million in assets at the death of the first spouse. We utilize an A-B Trust to divide the estate in equal shares because the entire estate consists of community property in which each spouse owned a one-half undivided interest in each asset. The spouses wished to include asset protection measures in the decedent's Trust B to ensure that one-half of the Trust estate was protected from the surviving spouse's liability or catastrophic illness expenses in order that the children would have an inheritance. At the same time, the decedent's Trust B could provide income to the surviving spouse.
As a result, Trust B provides advantages of conditional asset protection and income to the surviving spouse. But what about tax advantages? All assets funded into Trust B will never incur estate tax as long as the value of the assets are within the federal estate tax exemption amount -presently $5.2 million per person.
The assets included in the surviving spouse's Trust A are not taxed on the death of the first spouse. However, what happens on the death of the surviving spouse? Might there be estate or capital gains tax at the time? If the survivor's estate is valued within the then existing federal estate tax exemption there is no estate tax. But what if the Congress has reduced the exemption? Or what if the survivor's estate has increased above the exemption amount? As a result, there could be estate tax in the survivor's estate. Additionally, if the decedent's Trust B had not been arranged, there is a much more likelihood of estate tax on the survivor's death since we have abandoned the first deceased spouse's exemption.
But let's assume we have been prudent and arranged the B Trust and there are no estate tax issues. What about capital gains tax? In our scenario both the home, funded into the survivor's Trust A, and the rental property in Trust B have each appreciated an additional $500,000 at the time of the survivor's death.
The home which received a step-up basis on the death of the first spouse will get a second step-up in basis on the death of the surviving spouse to wipe out all capital gain on that asset. As a result, the children may sell the home at that time and pay no capital gains tax. Why is the basis stepped-up again? Because the home is owned by the surviving spouse in Trust A and includable in such estate under § 1014 of the IRC. All assets included in the estate of the surviving spouse are taxable for federal estate tax and will be taxed except for the individual aforementioned exemption. Furthermore, all assets included in the estate of the decedent will obtain a step-up in basis. This is a key in tax law.
How about that rental property we placed in Trust B at the first deceased spouse's death? It has appreciated $500,000 since that death but does it get an additional step-up in basis? Normally not. I say normally as that is based on conventional planning. But we are undertaking creative tax planning and desire to negate any capital gains tax in either Trust A or Trust B. We know that any assets funded into Trust B are not included in the survivor's estate. That is why we arrange Trust B. But what if we wish to include all or a portion of Trust B assets in the survivor's estate, especially the rental property which appreciated by $500,000 and is now valued at $1.5 million? If that asset is included in the survivor's estate, we can receive a second step-up in basis on that asset negating the capital gains tax.
So, how can we arrange this? By the inclusion of a general power of appointment over all, or a portion, of Trust B assets. The general power of appointment gives the holder, the surviving spouse, the power to appoint such assets to anyone, including themselves. This power equates with ownership and causes the assets to be includable in the estate of the holder of the power. The challenge, of course, is including assets of Trust B in the estate of the surviving spouse, without exceeding his/her exemption and creating federal estate tax (FET) in the estate.
Thus, the attorney must be careful in drafting a formula to accomplish this objective without subjecting the survivor's estate to a 40% marginal rate of estate tax. Success in this regard renders the Trust estate to the children or other beneficiaries entirely free of tax.