Many clients and their financial advisers mistakenly think a living trust lowers income taxes or guarantees a step-up in basis for capital gains. Generally, that is not the case.
Under Internal Revenue Code § 1014, when a person dies, capital assets owned by that person receive a step-up (or step-down) on basis to the fair market value as of the date of death. This can significantly reduce capital gains tax if the asset is later sold.
Capital Gain Tax = Sale Price (-) Adjusted basis
What Assets Receive a Step-Up on basis?
Only capital assets, such as real estate and stocks, receive a step-up on basis.
Retirement accounts (such as IRAs and 401(k)s) and other ordinary income assets do not receive a step-up on basis.
Two Opportunities for Step-Up on basis
There are two potential times when a step-up on basis may occur:
1) When the first spouse dies; and
2) When the surviving spouse dies.
Ideally, you structure ownership to obtain the first step-up at the death of the first spouse. This allows the surviving spouse to sell the asset during his or her lifetime with little or no capital gains tax.
Even if you do not obtain the first step-up, a step-up will occur at the death of the surviving spouse. In other words, your children will receive a step-up on a basis when both spouses have passed. In another word, if you are not selling the assets, you don’t need the first step-up on the basis.
How to Obtain the First Step-Up on basis
California is a community property state. Each spouse generally owns a 100% interest in community property assets even though it looks like the spouse only owns 50%. Therefore, if an asset is properly characterized as community property, 100% of the asset (not just the decedent’s 50%) receives a full step-up on basis upon the death of the first spouse, even though the surviving spouse is still alive.
To obtain the full 100% step-up at the first spouse’s death, assets should be:
1) Held in both spouses’ names; and
2) Characterized as community property (preferably titled as community property with right of survivorship).
Importantly, the community property character must be properly established before transfer to the living trust. Merely placing property into a trust does not convert separate property into community property.
People often do not understand that “Joint Tenancy” is a form of a separate property title. Simply holding property as joint tenants does not automatically guarantee the same full step-up in basis result as community property. Although California is a community property state, spouses must clearly establish community property status. Either by taking title as community property in writing or by obtaining a court order confirming its character. If you hold assets as joint tenants, you are affirmatively choosing a separate property form of title, which may override the community property presumption unless there is clear evidence showing a different intent otherwise.
Real Estate
If you currently hold real estate as joint tenants, I typically send a set of questions to determine whether the property qualifies as community property under California law. If the answers support community property characterization, I will adjust the titling appropriately when transferring the property into your living trust. If the answer does not satisfy the community property rules, i.e. it is one of your pre-marital assets or an inherited assets, I cannot change the title to community property. You need to find a family law attorney to transmute the property from separate property to community property.
As an estate planning attorney representing both spouses, I cannot unilaterally change separate property into community property. Doing so would violate the duty of loyalty I owe to the spouse who owns the separate property.
A spouse who intends to convert separate property into community property should consult with independent legal counsel to fully understand the legal rights being relinquished and the consequences of that decision before any such change is made.
Stock and Brokerage Accounts
In my experience, some financial institutions (such as Fidelity or Charles Schwab) may title joint accounts as community property but fail to specify “with right of survivorship.” If the titling is only under “community property”, the account must go through a probate proceeding when one spouse dies. Therefore, you do not want to simply transfer your joint tenancy brokerage account to community property account. It may cause probate proceeding when one spouse dies.
What You Should Do
1) Carefully confirm how a financial account is titled; and
2) You can change the account from joint tenants to community property but you must name the trust as the beneficiary.
If Property Was Already Transferred to a Trust
If you transferred real estate into your living trust with your previous attorney before consulting me, one possible solution is to prepare a postnuptial agreement confirming that jointly owned real estate and jointly owned brokerage accounts are community property. I can give you a quote. Very few legal plans cover postnuptial agreements. This may help secure the full step-up on basis at the first spouse’s death.
If the surviving spouse does not sell the asset after the first death, a step-up on basis will still occur at the death of the surviving spouse. At that time, your children will receive the stepped-up on basis.
