A traditional grantor retained annuity trust (GRAT) or a traditional qualified personal residence trust (QPRT) can be used to obtain a valuation discount for federal gift tax purposes while removing the trust property from your estate for federal estate tax purposes (if you survive the trust term). By modifying a few trust provisions, a step-up GRAT or QPRT can be used instead to obtain a stepped-up income tax basis for appreciated property, regardless of whether you or your spouse dies first. If you are considering a GRAT or a QPRT, you should consult an estate planning attorney.
What is income tax basis?
Income tax basis is the base figure used to determine whether capital gain or loss is recognized on the sale of property for income tax purposes. Initially, basis is typically equal to the amount you paid for property, but adjustments may be made. If the property is sold for more than its adjusted basis, there is a gain. If the property is sold for less than its adjusted basis, there is a loss.
What is a stepped-up basis for inherited property?
When your heirs receive property from you at your death, they generally receive an initial basis in property equal to its fair market value (FMV). The FMV is established on the date of your death, or sometimes on an alternate valuation date six months after your death. This is often referred to as a “stepped-up basis” because basis is typically stepped up to FMV. However, basis can also be “stepped down” to FMV.
There is no step-up (or step-down) in basis for income in respect of a decedent (IRD). IRD is certain income that was not properly includable in taxable income for the year of the decedent’s death or in a prior year. In other words, it is income that has not yet been taxed. Examples of IRD include installment payments and retirement accounts.
A step-up in basis is not available if you give appreciated property to anyone within one year of that person’s death and the property then passes to you (or your spouse).
Both spouses’ shares of community property qualify for a step-up (or step-down) in basis upon the death of the first spouse to die.
So how can you and your spouse be fairly certain of a step-up in basis for appreciated property (excluding IRD, which cannot be stepped up), regardless of who dies first? Except for community property, whether there is a step-up in basis when the first spouse dies generally depends on that spouse owning the appreciated property at death. A couple of step-up trusts may help provide for a step-up in basis for appreciated property no matter which of you dies first.
What is a traditional GRAT or QPRT?
In a traditional GRAT, you transfer property to the trust and retain a right to a stream of payments from the trust for a term of years. After the trust term ends, the remaining trust property passes to your beneficiaries (such as your children). The gift of the remainder interest is discounted (possibly to zero) because it will be received in the future.
With a traditional QPRT, you transfer your personal residence (it can be a vacation home or a second residence) to the trust, while retaining the right to live in the residence for a term of years. After the trust term ends, the personal residence passes to your beneficiaries (such as your children). The gift of the remainder interest is discounted because it will be received in the future. If you wish to live in the residence after the trust term ends, you need to pay rent at fair market value.
How do you turn a traditional GRAT or QPRT into a step-up GRAT or QPRT?
In order to turn a traditional GRAT or QPRT into a step-up GRAT or QPRT, a few trust provisions must be changed when the trust is created. First, the trust should terminate upon the earlier of the death of you or your spouse (rather than at the end of a term of years). Second, the trust should provide that when that death occurs, the trust property would pass to your spouse, or to your spouse’s estate if your spouse predeceases you (rather than to other beneficiaries). Your spouse provides in a will that the property in his or her estate passes back to you if your spouse predeceases you.
The initial transfer of a remainder interest in the trust to your spouse generally qualifies for the marital deduction for gift tax purposes.
If you die first, all or a substantial portion of the property in the step-up GRAT or QPRT will generally be included in your estate and receive a step-up in basis. If your spouse dies first, all of the property in the step-up GRAT or QPRT will be included in your spouse’s estate and will generally receive a step-up in basis. In either case, the property passes to the surviving spouse and should generally qualify for the marital deduction and avoid estate tax.
If your spouse dies first and within one year of your transfer to the trust, a step-up in basis is not available because the property passes back to you.
Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2016