Including Property in the Gross Estate to Get a Basis Step-Up

Overview

Before 2013, the estate planning technique for persons with modest to high wealth was to engage in planning techniques that would ensure the sufficient amounts of property would not be included in the gross estate at death.  That’s because the estate tax exemption was less than it is now and the federal estate tax rate was higher.  However, with a law change that took effect at the beginning of 2013, the federal estate tax exemption was increased to five million dollars per decedent, became coupled with the gift tax exclusion and was also indexed for inflation.  In addition, the estate tax exemption was made portable between spouses by election.  The inflation-adjusted exemption presently is $5.45 million per decedent.  For most people, that means that the federal estate tax is largely a non-issue.  Some states do impose taxes at death, however, and those that do typically have lower exemptions than the federal exemption.  That’s a concern for those either living or having property in those states at the time of death. 

Planning for a Basis Increase

So, while federal estate tax may not be an issue, income tax basis is a big issue.  Because of the relatively high level of the exemption, a planning strategy for many might be to deliberately cause inclusion of property in the estate at death so that the heirs can get an income tax basis in the property equal to its fair market value at the time of the decedent’s death.  A couple of common techniques for getting a basis step-up involve life estates and powers of appointment.

Life Estate

If an individual makes a gift of property, but keeps some powers over the property, those retained powers will pull the property back into the donor’s estate. The retained power to revoke, alter, amend or terminate the transfer causes inclusion of the property subject to the power in the transferor’s estate.  For example, a parent may gift a farm or ranch to the children during life, but retain the right to income for life.  This retained right to the income pulls the property back into the parent’s gross estate with the result that the heirs will get a stepped-up basis in the property equal to its fair market value at the time of the parent’s death.  While the property would potentially be subject to federal estate tax in the parent’s estate, the $5.45 million exemption will likely eliminate any federal estate tax.

For those that have larger estates where federal estate tax might be a concern, rather than gifting property and retaining a life estate, the strategy might be for the parents to sell the remainder interest in the farm or ranch to the children, but retain a life estate interest in the transferred property.  If the sale of the remainder interest is bona fide and is for full and adequate consideration, the value of the retained life estate should not be included in the seller’s gross estate upon death.  The IRS prescribes tables that can be used to value the remainder interest, with the value depending upon the seller’s life expectancy.  The IRS historically took the position that the sale of a remainder interest at its actuarial value requires the retained life estate to be valued in the seller’s estate at its date of death fair market value less the value of the remainder interest that was sold.  However, the U.S. Courts of Appeal for the Third, Fifth and Ninth Circuits have rejected that position and have held that the bona fide sale of a remainder interest for its actuarial fair market value did not cause the value of the retained life estate to be included in the decedent’s gross estate.

Power of Appointment

The gross estate also includes property over which the decedent possessed a general power of appointment.  That’s the power to direct the distribution of another person’s property.  There are two different types of powers of appointment.  One is called a “general power.” With a general power of appointment, the holder gets the power to designate who gets the property subject to the power, including the holder.  The power is exercisable in favor of the holder of the power, the holder’s estate, the holder’s creditors, or creditors of the holder’s estate.  A general power is fully taxable because it pulls all of the property subject to the power into the power holder’s estate.  On the other hand, a form of a special power is one that is limited by an ascertainable standard (health, education, welfare or maintenance).  The property subject to such a power is not taxed in the power holder’s estate.  The drafting language that is used with the intent to create an ascertainable standard is critical.  In general, a special power of appointment is a power exercisable in favor of anyone except the holder of the power, that person’s estate, that person’s creditors or the creditors of that person’s estate or a power limited by an ascertainable standard, such as health, education, support or maintenance. Again, the property subject to a special power of appointment is not taxable to the holder of the power.

Gifts Within Three Years of Death 

It is also possible to cause property to be included in a decedent’s estate by gifting an asset too close in time to death.  For gifts made before January 1, 1977, all transfers made within three years of death that were “in contemplation of death” were included in the gross estate.  All gifts made within three years of death for persons dying after 1976 and before 1982 were included in the gross estate unless a federal gift tax return was not required to be filed.  For deaths after 1981, the three- year rule applies only in specified instances. These instances include situations where (1) the decedent retained a life estate in the property, (2) the transfer is to take effect at death, (3) the transfer is revocable, or (4) the transfer involves a transfer of ownership in a life insurance policy on the decedent’s life.  For some people, this rule comes into play with respect to life insurance.  If life insurance ownership is transferred by gift from the insured within three years of the insured’s death, the full amount of the face value of the policy is included in the insured’s gross estate. For example, if a husband buys a policy that insures his life and then gifts the policy to his wife and dies two years after making the gift, the entire value of the policy will be included in his estate.  Similarly, if the husband makes a cash gift to his wife and the wife uses the cash to buy a life insurance policy on her husband’s life and the husband dies six months later, the policy proceeds are included in his estate if the transfer is one “with respect to an insurance policy.”  So, if the idea is to not cause inclusion in the estate, then the cash gift should not equate to what is needed for the insurance premium payment, and the cash should not be gifted immediately before the premium due date.  Alternatively, if the wife buys a policy on her husband’s life, but the husband pays the premium each year and dies within three years of the wife’s purchase, the proceeds are not included in the husband’s estate.

Conclusion

There are other techniques that can be used to cause inclusion of property in the decedent’s estate, including disclaimer wills and joint exempt step-up trusts.  Inclusion of property in the estate has become a big deal after 2012.  The federal estate tax is a big deal when it applies, but it applies in relatively few instances.  However, everyone is concerned with income tax basis. 

Just some things to think about when you next update your estate plan.