Editor’s note: This is part nine of an ongoing series about using trusts and LLCs in estate planning, asset protection and tax planning. The effectiveness of these powerful tools — especially for asset protection and tax planning — depends very much on how they are configured to work together and whether certain types of control over assets and property are surrendered by the property owner. See below for links to the other articles in the series.
Political candidates occasionally promise to get rid of the “death tax,” by which they mean the estate tax. “Doing away with the death tax” makes a solid soundbite for an aspiring politician because no one likes death and no one likes taxes. However, this populist campaign strategy is a farce and always comes with the major tax string of taxing “unrealized appreciation upon death under the capital gains tax.”
The problem with repealing the unpopular death tax and instead taxing unrealized appreciation under the capital gains income tax regime is that most voters don’t understand the terribly taxing result of this trade-off. The voters are blithely happy to hear that the political candidate will vote for the repeal of the death tax, but they are unaware that the capital gains tax levied on unrealized appreciation will be used as a proxy for death taxes. However, the death tax under a different name stinks just the same, and more people would pay higher taxes upon death under the capital gains income tax regime than they are paying under the current estate transfer tax regime.
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Just in case you think you are the only person who feels the way you do about the various income and transfer taxes applicable to trust and estate taxes, the following real-life example illustrates how most people feel about the trade-offs they must make when forming a trust, balancing between estate tax, gift tax and capital gains tax consequences:
Example. A trust maker meets with an attorney to form an irrevocable trust that will protect the trust maker’s unimproved land and avoid the death tax. The attorney explains to the trust maker that to exclude an asset from the trust maker’s gross estate to avoid death taxes, the trust maker must permanently transfer the assets to a trust, retaining no possession or enjoyment over the land, and give up control over managing the land. Additionally, the attorney informs the trust maker that after deeding the land into the irrevocable trust, the trust maker is required to file a gift tax return, using IRS Form 709. The trust maker purchased the land for $1 million, and now the land is worth $10 million. The attorney explains that the trust maker’s basis in the land is $1 million, and that basis will transfer to the irrevocable trust. The attorney explains that if the trust maker’s beneficiary later sells the land for a purchase price of $10 million, the beneficiary of the trust must pay capital gains taxes. The attorney calculates that upon sale, the federal capital gains tax will be assessed at the maximum 20% on the appreciation above the trust maker’s purchase price. In addition to the federal capital gains tax, the beneficiary will owe an additional 3.8% for the federal net investment income tax (NIIT), plus the state where the land is located will charge a capital gains tax of 5%. The combined federal and state capital gains taxes will be 28.8% on $9 million, for a total capital gains tax burden of $2.6 million. The trust maker exclaims, “Ahhh! I hate taxes!”
A deeper dive into capital gains taxes
Now that you have commiserated with other fellow humans about your sentiments toward taxes, let’s take a bit deeper dive into capital gains taxes. To summarize, the U.S. primarily applies two interchangeable tax regimes to trusts and estates:
- Income tax, including the capital gains tax
- Transfer taxes, including the estate, gift and generation-skipping transfer taxes
Capital gain taxes are the tax on the sale of appreciated assets, and the trade-offs between capital gains taxes and estate taxes make trust income taxes a bit nuanced. Capital gains taxes are codependent with trust estate taxes. A good way to explain the capital gains tax as a general concept is to say, “Uncle Sam appreciates your appreciation — and he wants to take a cut of it.” Put differently, when you make a good investment and later sell it — when you “buy low and sell high” — Uncle Sam wants to tax your asset appreciation, or capital gains.
It is important to reiterate the fact that keeping assets out of the trust maker’s gross estate may not actually be a desirable outcome because of the trade-offs between estate tax and capital gains. Sometimes a person thinking about setting up a trust wants to get the biggest bang for their buck and insists that they not only want an irrevocable trust for asset protection, but they also want the irrevocable trust to remove assets outside of their estate to avoid estate taxes, which can be as much as 40% in 2024. However, there is a trade-off in the Internal Revenue Code (IRC) between estate taxes and capital gains taxes that makes it worth considering a revocable trust (or an incomplete gift irrevocable trust).
Example. A retired parent wants to set up an irrevocable trust to protect their assets, avoid estate taxes and pass on their home and assets to their children. The parent consults with an attorney. The attorney and the parent determine that the parent has low risks (no job, no business, no rentals), and the parent is not subject to federal estate tax. However, the parent purchased their home 30 years ago for $500,000, and the home is now worth $3 million ($2.5 million of appreciation). The attorney explains to the parent that if they transfer the home into an irrevocable trust, that will certainly avoid estate taxes (a completed gift irrevocable trust), but the parent will not get a step-up in basis to the value of the home at the time of death. Under a completed gift irrevocable trust, if the parent were to pass away while the home is still worth $3 million, the children would need to pay about $720,000 of capital gains taxes (20% federal capital gains, 3.8% federal NIIT, and 5% in state taxes). The attorney explains that if the parent were to instead structure the irrevocable trust so that the trust will include the home in the parent’s gross estate, the parent’s exemption from estate tax would not only avoid estate tax, but also avoid capital gains tax through the step-up in basis to time-of-death value provided under Section 1014 of the IRC.
The result in this example highlights that although a potential 40% estate tax is no small thing, keep in mind that most people (other than the wealthy) are exempt from estate tax, but if they transfer trust property outside of their gross estate, they will be stuck paying about 20% to 30% in federal and state capital gains taxes. The exact amount of capital gains taxes depends not only on the state assessing the tax, but also on the tax bracket of the person against whom the capital gains tax is being assessed.
When rental properties or LLCs are involved
An irrevocable trust is usually the right trust choice for individuals with rental properties or potential professional liabilities, and irrevocable trusts provide superior asset protection for trust makers who own or are acquiring rental properties or investment real estate — especially when coupled with LLCs. However, if an individual’s total wealth will not net out to about $7 million dollars in 2026, then either an irrevocable trust, which intentionally keeps assets in the trust maker’s gross estate (an incomplete gift irrevocable trust), or a revocable trust could save the trust maker’s beneficiaries from paying as much as 30%-plus in federal and state capital gains income taxes.
The capital gains tax savings advantage of an incomplete gift irrevocable trust or a revocable trust is due to an income tax rule which, upon the death of the revocable trust maker, gives a trust property extra exemption from capital gains taxes by virtue of a step-up in basis of the assets. The exemption from capital gains tax is like a reward given to the beneficiaries of trust assets that are included in the (potentially) taxable gross estate of the deceased trust maker.
Keep in mind that in calculating whether the trust maker’s total assets will be taxable, you must include any property over which an individual has possession and enjoyment. The gross estate includes assets inside of an incomplete gift irrevocable, assets in a revocable trust and assets outside of a trust, such as financial accounts, investments, retirement accounts and insurance. Again, even if assets are in a revocable trust or incomplete gift irrevocable trust, and even if the assets (such as retirement, bank and investment accounts or life insurance) list a beneficiary, those assets are still included in the potentially taxable gross estate.
Deciding between estate tax and capital gains tax
To summarize, trust makers must calculate the trade-off between potentially paying the estate tax (currently 40% federal) vs capital gains taxes (currently 20% federal). Although it may seem obvious that it is less costly to pay 20% tax rather than 40% tax, several values and exemption amounts must be considered in calculating the best approach to estate tax and capital gains tax planning. The variables include:
- The future amount of estate tax exemption at the time of the trust maker’s death
- The trust maker’s basis in the property
- The future value of the property
Unfortunately, these tax-affecting values can change often, depending on outside forces like Congress and the economy. Here is a very simplified example of the capital gains tax and estate tax trade-offs:
Example. A trust maker wants to form an irrevocable trust to protect unimproved land currently valued at $50 million, with a purchase price basis of $5 million. An attorney advises the trust maker that the estate tax exemption is currently $13.61 million (in 2024), but the estate tax exemption will sunset at the end of 2025 to about $5 million plus inflation. The attorney also explains to the trust maker that they must decide whether the irrevocable trust is excluded from the trust maker’s gross estate, causing future capital gains taxes when the property is sold, vs including the trust in the trust maker’s taxable estate, preventing future capital gains taxes but incurring estate taxes. The attorney roughly calculates that federal estate taxes on $50 million would be about $14.5 million and compares this against federal capital gains taxes of $9 million. The trust maker decides that they would rather pay $9 million in capital gains and decides to complete the gift of the land into the irrevocable trust to permanently remove it from the estate.
It is important to point out that this example of the trade-off between estate tax vs capital gains taxes is overly simplified. It does not account for state and local taxes or NIIT, nor does it consider myriad complex estate planning techniques such as sales, partnership discounts or annuities that can be used to mitigate estate tax and capital gains taxes. It should also be noted that for a smaller estate of around $20 million or less, the estate tax would almost certainly be bigger than the capital gains tax, leading to the opposite conclusion that the asset should be included in the potentially taxable gross estate of the trust maker.
It is essential that a trust maker carefully consider the trade-offs in trusts that exclude the trust assets from the grantor’s gross estate to prevent the potential of estate taxes, because assets in a trust that are removed from the trust maker’s gross estate will not receive a step-up in basis to save on the often more expensive capital gains taxes under IRC 1014.
My next article will cover gift and estate tax tradeoffs with capital gains taxes.
Other Articles in This Series
- Part one: To Avoid Probate, Use Trusts for Estate Planning
- Part two: How Quitclaim Deeds Can Cause Estate Planning Catastrophes
- Part three: Revocable Trusts: The Most Common Trusts in Estate Planning
- Part four: With Irrevocable Trusts, It’s All About Who Has Control
- Part five: Ins and Outs of Domestic Asset Protection Trusts (DAPTs)
- Part six: Irrevocable Trusts: Less Control Equals More Asset Protection
- Part seven: Should You or the Trust Pay a Trust’s Income Taxes?
- Part eight: How to Handle Irrevocable Trust Assets Tax-Efficiently
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