The average American is generally unconcerned with federal estate taxes because exclusions are historically high. As of 2020, this federal transfer tax only applied to an estimated 0.2% of deceased Americans, those of which are said to have passed with a “taxable estate.” For the remainder of Americans, the federal estate tax is not a going concern, even if they pass after 2025 when the exclusions are set to be reduced by half.
However, individuals with non-taxable estates can still take advantage of sky-high exemptions to minimize a different type of tax: capital gains tax. Specifically, they can make use of an older generation’s available exemption to re-adjust the basis of highly appreciated capital assets through a strategy known as “upstream gifting,” explained below. At the very least, most taxpayers with highly appreciated assets should consider the impact of basis planning before making any lifetime gifts or finalizing their estate plans.
First, it is important to understand what “capital gain” is and how it is calculated. Capital gain is determined by subtracting an asset’s “basis” from its fair market value, i.e., its sale price. Simply put, the basis of an asset is its initial purchase price (plus additional qualified expenses, such as improvements), less any depreciation that taxpayer may have applied to that asset over the course of holding it.
For example, if an individual invested $100,000 in a vacation property in 2004, and over time, made $50,000 worth of improvements, he would have a resulting basis of $150,000 in that property ($100,000 + $50,000). The capital gain is determined by calculating the difference between the basis and the actual sale price. If the individual in the example above were to sell the property in 2024 for $400,000, he or she would realize a $250,000 capital gain, which would then have a capital gains tax levied against it (typically taxed between 15–20%, plus an additional 3.8% net investment income tax for some).
For taxpayers who do not wish to sell highly appreciated assets and recognize capital gain, it is important to consider an asset’s basis in relation to how, in the future, the asset may be transferred; How an asset is transferred will impact its basis and therefore any capital gains tax levied upon its eventual sale. Taxpayers who hold highly appreciated assets should be aware of two crucial tax concepts: “carry over basis” and “step up basis.”
Typically, when a donor makes a lifetime gift, the donor’s basis in such asset “carries over” to the donee. Any gain recognized on a subsequent sale of such asset is calculated using the donor’s basis and taxed accordingly. However, if the highly appreciated asset instead transfers upon the donor’s death the basis is “stepped up” (i.e., readjusted to the fair market value upon the donor’s death), eliminating any built-in gain.
The donor in the example above may have been tempted to gift the highly appreciated real estate to his daughter, but doing so during his lifetime rather than upon his death would result in a larger tax bill if she were to later sell the property.
Savvy investors or small business owners who realize the power of basis step up may consider gifting highly appreciated assets to parents or other older relatives with modest estates, the thought being they would inherit the assets back with a now stepped-up basis. Using a different example, imagine in 2008 a taxpayer purchases 50,000 shares of AMZN for $2.50/share, resulting in a $125,000 basis. In 2021, the taxpayer gifts the shares, then valued at $151 per share, to their father, who takes those shares with a $125,000 basis carried over from the taxpayer. The father passes away in 2024 when AMZN stock is worth $181 per share, leaving the 50,000 shares to the donor in his estate plan, owing no estate tax due to his large available estate tax exemption.
The shares bequeathed back to the taxpayer receive a new “stepped-up” tax basis of $181 per share, thereby eliminating a built‑in gain of $178.50 per share. If the AMZN shares are immediately sold, this translates to a $1.34MM–$1.79MM reduction in capital gain tax had they otherwise been sold just before their father’s death.
Individuals contemplating this approach should understand the risks — namely loss of control, assets being reachable by a parent’s creditors, utilization of the transferor’s own lifetime gift and estate tax exemption, time-based survival requirements, and inadvertently creating a taxable estate for the parent.
The taxpayer might avoid these traps by placing the AMZN shares in an irrevocable trust for benefit of themselves and their father (preferably in a New Hampshire non-grantor asset protection trust) giving their father a formulaic testamentary general power of appointment. This power, which merely allows the father to direct distribution to any person (including themselves), triggers step-up in basis even when unexercised. There is no requirement that the father holds title to or otherwise controls the highly appreciated AMZN shares during his lifetime.
Any person looking to engage in this technique should first consult an experienced estate planner.
Joshua R. Weijer, Esq. is a member of McLane Middleton’s Trusts & Estates Department. He advises clients in a number of areas including estate planning, tax planning, fiduciary matters, and estate and trust administration. He can be reached at joshua.weijer@mclane.com.
