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Capital Gains Tax and Credit Shelter Trusts

By Howard C. Stross
January 24, 2014

Capital gains tax is assessed on the profit, or gains, when an asset is sold. Capital gains tax is based on the difference between an asset’s basis, which is usually the purchase price, and its sales price.

For example, Bill and Mary buy a rental home for $50,000. Twenty years later, they sell the home for $200,000. Their basis is $50,000. They will pay capital gains tax on the $150,000 gain. The capital gains tax rate they will pay depends on their taxable income.

Capital Gains Tax Rates

Generally, for most taxpayers the rate for capital gains tax is 15%. However, if your taxable income is in the 39.6% tax bracket ($400,000 for single and $450,000 for married filing jointly), your capital gains tax rate is 20%. Also, for taxpayers in the 10% or 15% tax bracket, their capital gains tax rate is 0%.

What is a Stepped-Up Basis?

Typically, an asset’s basis is the purchase price. However, beneficiaries receive a stepped-up basis. Instead of the basis being based on the purchase price, the basis is the value of the asset at the death of death.

Changing our scenario, instead of selling the rental home, Bill passes away and Mary inherits the home. Then Mary passes away and leaves the home to their daughter. Their daughter’s basis is not the $50,000 purchase price. Instead, her basis is the value of the property on the date of Mary’s death. If it is worth $200,000 on Mary’s death and her daughter sells the property for $200,000, she doesn’t pay capital gains tax.

Warning: if you gift an asset to your child when you are still alive, there is no stepped-up basis. In that case, your child will have the same basis you have.

Capital Gains Taxes and Credit Shelter Trusts

Currently, one objection to credit shelter trust planning is the possibility of additional capital gains taxes on the surviving spouse’s death.

Let’s say when Bill passes away, the home is worth $180,000. He leaves Mary the home in a credit shelter trust. Then when Mary passes away, the home is worth $200,000. Depending on how the credit shelter trust is drafted, the daughter’s basis would be $180,000 (the value at Bill’s death) and there would be no stepped-up basis on the second death because the credit shelter trust assets avoid estate tax on Mary’s death.

Capital gains tax rates have been lower than federal estate tax rates, so planners have assumed that it would be preferable to avoid federal estate taxes even when there is capital gains tax exposure. Now that the unified credit is $5,340,000, planners assume that many families will not need estate tax avoidance strategies and that exposure to capital gains tax is too great a price to pay.

Must married folks doing estate planning choose between federal estate taxes or capital gains tax? The answer is NO!

A credit shelter trust can be structured to minimize estate tax if there is estate tax exposure at the surviving spouse’s death or to maximize the basis step-up, thereby minimizing capital gains tax after the second death.

This can be done by giving the surviving spouse a general power of appointment over an amount of trust property that would not trigger federal estate tax. Powers of appointment are a way to allow a trust beneficiary to direct where a trust goes after their death. If a beneficiary has a general power, the trust is included in the beneficiary’s estate. In this case, the general power is conditional because the surviving spouse only has it if there is no estate tax exposure.

This is the third article in a series about credit shelter trusts. The first blog of this series presented three reasons clients may want a credit shelter trust that don’t have anything to do with federal estate taxes. The second blog evaluated the pros and cons of three options for how married clients can leave their estate to their spouse.

Hopefully you can see now that credit shelter trust planning is alive and well and is an important tool.

This article is for general information and not intended to provide tax, accounting or legal advice. Would you like to know more about how powers of appointment can be used in trusts to create flexibility for the unknowable future? Call us at 813-852-6500 to schedule a free 30-minute consultation with an estate planning lawyer.

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