The estate tax exemption won’t always be so high. The runup in housing prices may mean capital gains taxes become a serious issue for many people. There are solutions to be found in estate planning, including one known as an “Upstream Power of Appointment” Trust, as explained in the article “How to Use Your Estate Plan to Save on Taxes While You’re Still Alive!” from Kiplinger.
The strategy isn’t for everyone. It requires a completely trustworthy, elderly and less wealthy relative, such as a parent, aunt, or uncle, to serve as an additional trust beneficiary. First, here is some background information:
Basis: This is the amount by which a price is reduced to determine the taxable gain. This is often the historical cost of an asset, which may be adjusted for depreciation or other items. Estate planning attorneys are familiar with these terms.
Step-up (in-basis): If you bought a house for $100,000 and sold it for $400,000, your taxable gain would be $300,000. However, if the house had belonged to your father and was being sold to distribute assets between you and your siblings, the basis (cost) would be increased to the fair market value at the date of your father’s passing. This increase is known as the “step-up in basis” and here’s the benefit: there would be no capital gain on the sale and no taxes owed.
Lifetime estate tax exemption: This is currently at $12.06 million per person or $24.12 for married couples. This is the amount of assets which can be passed to children or others free of any federal estate tax. However, the number will take a deep dive on January 1, 2026, when it reverts back to just under $6 million, adjusted for inflation. Plan for the change now, because 2026 will be here before you know it!
Upstream planning involves transferring certain appreciated assets to older or other family members with shorter life expectancies. Since the person is expected to die sooner, the basis step-up is triggered sooner. When the named person dies, you obtain a basis step-up on the asset, saving income taxes on depreciation and saving capital gains on a future sale of the property.
Most Americans aren’t worried about paying estate taxes now, but no one wants to pay too much in income taxes or capital gains taxes.
To make this happen, your estate planning attorney will need to give an elderly person (let’s say Aunt Rose) the general power of appointment over the asset. Section 2041 of the Internal Revenue Code says you may give your Aunt Rose a power to appoint the asset to her estate, creditors, or the creditors of her estate. Providing the power will include the value of the property in her estate, not yours, ensuring the basis step-up and income tax savings.
Don’t do this lightly, as a general power of appointment also gives Aunt Rose ownership and the right to give the property to herself or anyone she wishes. Can you protect yourself, if Aunt Rose goes rogue?
While the IRC rule doesn’t require Aunt Rose to get your permission to control or change distribution of the property, a trust can be crafted with a provision to effectuate the desired result. The IRC doesn’t require Aunt Rose to know about this provision. This is why the best person for this role is someone who you know and trust without question and who understands your wishes and the desired outcome.
Proper planning with an experienced estate planning attorney is a must for this kind of transaction. All the provisions need to be right: the beneficiary need not survive for any stated period of time, you should not lose access to the assets receiving the basis increase, you want a formula clause to prevent a basis step down if the property or asset values fall and you want to be sure that assets are not exposed to creditor claims or any other liabilities of the person holding this broad power.
Reference: Kiplinger (July 3, 2022) “How to Use Your Estate Plan to Save on Taxes While You’re Still Alive!”