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The Tax Balancing Act: Minimizing Estate Tax and Maximizing Income Tax Basis

By Jana L. Simons on January 25, 2019

The lifetime estate and gift tax exemption has risen more than 1600% over the past two decades. In 2017, with an exemption of $5,490,000, there were roughly 5,200 taxable estates but with an exemption of $11,180,000, that tally is expected to fall under 2,000 taxable estates for the 2018 tax year. As fewer estates are subject to federal estate tax, the intersection of estate tax planning and income tax planning is more pivotal than ever before. Under historically lower lifetime exemption regimes, estate planners generally focused on removing highly appreciated assets from estates to reduce anticipated estate tax liability. This trend has shifted to retaining asset with significant built-in gain in order to take advantage of a tax basis adjustment afforded to assets that pass at death, pursuant to I.R.C. § 1014. Considering recent fluctuations in the lifetime exemption amount—currently $11,400,000 in 2019 but scheduled to return to the inflation-indexed equivalent of $5,000,000 in 2026—additional care may be necessary to effectively minimize estate tax liability while maximizing income tax basis on transferred assets.

Consider the following example. Elizabeth, whose net worth is $10,000,000, owns a parcel of real property which she purchased for $25,000 in 1979. Assuming no prior basis adjustments, her basis in the property is, therefore, $25,000. The property’s fair market value in 2019 was $1,000,000. If she gifts the property to her son, Charles, during her lifetime, his basis in the property will similarly be $25,000, retaining the property’s capital gains tax exposure. If instead, Charles inherits the property from Elizabeth at her death in 2019, he assumes ownership of the property with an adjusted basis of $1,000,000 (the fair market value of the parcel on the date of Elizabeth’s death). Charles’s subsequent sale of the property for $1,000,000 would yield zero capital gains tax. Furthermore, because Elizabeth did not exhaust any of her unified credit during life and her estate is under the 2019 lifetime exemption threshold of $11,400,000, her estate has no federal estate tax liability. The prudent option in this situation is clear: retain the property until death to obtain the basis adjustment income tax and estate tax free.

Unfortunately, however, the decision to simply create “free basis” for the beneficiary by retaining all assets with significant built-in gains can prove slightly more complex. Assume the same facts as above but, instead, Elizabeth dies in 2026, having elected to retain the property in her estate and forego the opportunity to transfer the asset to Charles prior to the sunset of the doubled lifetime exemption. At her death, Elizabeth’s Estate owes federal estate tax on the value of includable assets in excess of the $5,000,000 exemption (ignoring inflation indexing). Thus, while Charles receives the property with an adjusted basis, eliminating capital gains on his forthcoming sale of the property, the estate is subject to approximately $2,000,000 in federal estate tax (assuming Elizabeth did not use any of her unified credit during life). Alternatively, if Elizabeth had removed the property from her estate by gifting it to Charles during her life, Charles could face over $230,000 in capital gains tax on the $1,000,000 sale. Owning assets of only $9,000,000 at death, however, the estate would owe federal estate tax of $1,600,000. Under this scenario, gifting the property during life reduces the total aggregate income and estate tax by nearly $170,000 [calculated by netting the $400,000 estate tax savings on the reduced gross estate with the $230,000 capital gains tax imposed on the beneficiary’s sale of the gifted property].

For wealthy individuals, deciding whether to gift or retain assets can be a multifactorial decision. Some relevant considerations include the amount of built-in gain and potential appreciation of the assets, whether the recipient plans to sell or retain the assets, the estate’s anticipated estate tax liability in light of uncertain future lifetime exemption amounts, and the assets’ expected income production. For nontaxable estates, on the other hand, ensuring the individual’s property receives a basis adjustment through testamentary transfer is vital. 

Arrangements that were originally designed to reduce estate tax when the lifetime gift and estate tax exemption was a fraction of today’s $11,400,000 threshold, such as family limited partnerships or grantor trusts that are no longer be necessary or beneficial based on present circumstances, might deprive beneficiaries of valuable basis adjustments available under the current format. Regardless of an individual’s net worth, now is a worthwhile time to revisit tax and estate plans that have eluded recent review. With questions on this or any other tax or estate planning matter, please feel free to contact Jana Simons at or jsimons@meadowscollier.com.