In our last blog post, we discussed why the simple “I Love You” estate plan—where a married couple leaves everything to the surviving spouse—might not be sufficient for Washington State residents. We introduced the idea of using a trust to preserve the first spouse’s estate tax exemption, effectively reducing the estate tax burden for the surviving spouse. However, this strategy isn't without its potential drawbacks. Specifically, it can lead to the loss of a step-up in basis for assets held in the trust after the death of the second spouse. In this article, we’ll explain the step-up in basis issue and how to address it through careful estate planning.
The Step-Up in Basis: What Is It?
A step-up in basis is a tax provision that allows the basis of an asset—usually its purchase price or adjusted value—to be “stepped up” to its fair market value at the time of the owner's death. This is beneficial because if the asset is sold, capital gains taxes are only due on the increase in value from the date of death, rather than from the original purchase price.
For example, if a house was purchased for $100,000 and is worth $500,000 at the owner’s death, the step-up in basis allows the heirs to inherit the house with a $500,000 basis. If they sell it for $500,000, no capital gains tax is due. Without this step-up, they would owe capital gains tax on $400,000.
The Trade-Off: Preserving Estate Tax Exemption vs. Step-Up in Basis
When a trust is used to preserve the first spouse to die’s Washington estate tax exemption, the assets in that trust are not included in the surviving spouse’s taxable estate. While this reduces the estate tax liability, it also means that those assets may not receive a second step-up in basis when the surviving spouse dies. The result? The beneficiaries may face significant capital gains taxes if they sell the assets in the first spouse’s trust.
The Solution: Strategic Use of QTIP Trusts
Fortunately, there’s a way to potentially avoid this issue while still minimizing estate taxes. By incorporating a Qualified Terminable Interest Property (QTIP) election into your estate plan, you can preserve the first spouse’s estate tax exemption while also securing a step-up in basis for assets in the trust upon the death of the second spouse.
Here’s how it works:
Drafting the Trust: During the estate planning process, your attorney can draft a trust that meets the requirements for a QTIP election. The trust must provide that all income is distributed to the surviving spouse at least annually, and no one else can be a beneficiary during the spouse’s lifetime.
Making the QTIP Election: After the first spouse dies, a federal estate tax return is filed, and the QTIP election is made for the trust. This election treats the trust’s assets as part of the surviving spouse’s estate for federal estate tax purposes, allowing them to qualify for the marital deduction and a potential step-up in basis when the second spouse dies.
Washington State Consideration: For Washington State estate tax purposes, a 0% QTIP election can be made. This means that while the assets in the trust are included in the surviving spouse’s estate for federal purposes, they are not included for Washington State estate tax purposes, thereby preserving the first spouse’s estate tax exemption.
When to Consider This Strategy
This type of planning is particularly beneficial for estates that are not expected to exceed the federal estate tax exemption, currently set at $13.61 million per person. However, with the federal exemption potentially being reduced in the future, it’s essential to revisit your estate plan regularly to ensure it remains effective under current laws.
Conclusion
While using a trust to preserve estate tax exemptions is a powerful tool in Washington State, it’s crucial to consider the potential impact on capital gains taxes. By incorporating a QTIP election into your estate plan, you can potentially enjoy the best of both worlds: reducing estate taxes and securing a step-up in basis for your heirs. As always, it’s important to work with an experienced estate planning attorney who understands the nuances of Washington State law to ensure your plan accomplishes your goals.
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