For introductory purposes for non-tax professionals, when an individual
passes, the IRS treats any property they own as though it is sold with
a basis (original purchase price plus certain adjustments) of zero; thus,
the entire fair market value of the property is subject to taxation. However,
the unified credit exempts $5.34m from taxation, so there is no taxation
on the first $5.34m of assets. Nevertheless, the first $5.34m of property
exempt from taxation is still treated as though it were sold, so the heirs/beneficiaries
inherit the property with a tax basis equal to fair market value. This
is what we call a “step-up” in basis; it effectively eliminates
built-in gain subject to tax. The recipient could sell it the next day
and not have any taxable gain.
This led many to consider the idea of gifting assets to a soon-to-pass
relative in order to get this step-up in basis and avoid tax on the built-in
gains. However, the IRS also realized that taxpayers would think of this.
Under section 1014(e), if the recipient of gifted appreciated property
dies within one year of receiving the property
and the original person that gifted the property reacquires the property,
then the step-up in basis is denied. The spouse of the original person
that gifted the property is also covered. This led many practitioners
to assume the IRS had prevented the strategy of gifting your 1,000-acre
ranch to a soon-to-pass relative. Wrong.
The legislative history of section 1014(e) reveals congressional intent
to cover both direct and indirect transfer and acquisitions, including
transfers or acquisitions through a trust arrangement. Another defensive
measure by Congress. However, in the context of a trust, there are split
interests that must be independently valued in accordance with actuarial
Actuarial principles are mathematical calculations used to value certain
interests that are difficult to value. For example, if Jane gifts a ranch
property to her aunt the week before she passes, and the aunt’s
will gives the property back to Jane, then section 1014(e) prevents a
step-up in basis.
However, if the will transfers the property to a purely discretionary trust
for the benefit of Jane and her children, then the value of Jane’s
interest is elusive. In the context of a discretionary trust, the trustee
has total and complete discretion to disburse funds. In other words, the
trustee could give Jane nothing… or everything.
Also, if the property went back to a split interest trust where Jane merely
has a life estate, only a small fraction of the trust would be denied
the step-up in basis.
This is yet another opportunity that our clients have fully utilized to
avoid the U.S. estate tax.