Earlier this year, the IRS issued Revenue Ruling 2023-2 which clarifies when a "step-up in basis" would apply to inherited property. At issue is whether property passing to beneficiaries under an irrevocable trust would receive this a step-up in basis. Under this new ruling, the IRS makes it clear that the answer is "no."
Reviewing What a "Step Up in Basis" Is.
Remember "step up in basis" is a rule that can apply to capital gains on inherited assets. For a more complete overview, review our article on Estates and Taxes 101. But essentially the tax basis of an asset is how we calculate capital gains.
Ordinarily, if we have an asset like a house, our capital gains would be calculated by subtracting the purchase price of an asset from the sale price. The difference is the capital gain, which would then potentially be subject to tax.
If we were to inherit, for example, a home that had been owned by our parents for 30 years and apply this rule, then the capital gain would be the price that we sell it for today, minus the purchase price from 30 years ago. Because the purchase price from 30 years ago would likely be much less than we are selling it for today, the difference would likely result in a large capital gain. More gain equals more potential tax.
However, IRC Sec. 1014 and 26 CFR § 1.1014-2 set forth the step up in basis rule. Using our hypothetical example above, this rule changes how we calculate the capital gain. Rather than using the purchase price on our parents' home from 30 years ago, we would use the value of the property on the date our surviving parent died. Typically this means that the capital gain would be much, much lower. Therefore, less potential tax.
Irrevocable Trusts
Remember that, as a general principle, we talk about trusts either being revocable or irrevocable. This simply describes whether the creator of the trust has the power to revoke or amend the trust.
A revocable trust is a common type of estate planning tool that is used largely to avoid probate and simplify the process of passing assets to our heirs. Irrevocable trusts are often used for tax planning and Medicaid planning purposes, among other things. Part of the reason that irrevocable trusts are used for these purposes is that the creator of the trust no longer has complete control over the assets in the trust. As a result, this allows the creator of the trust to argue, for example, that the assets in the trust are no longer part of their taxable estate (for estate tax purposes) or a countable resource (for Medicaid purposes).
Can I Still Use a Revocable Trust and Receive a Step-Up in Basis?
The good news is that the language of Revenue Ruling 2023-2 makes it clear that it applies to trusts where the creator of the trust does "not retain a power to revoke or amend." As a result, a well-prepared revocable trust that falls within the requirements of IRC Sec. 1014 should still enjoy the ability to transfer assets with a step-up in basis.
However, the ruling does make it clear that use of irrevocable trusts can create a situation where assets no longer enjoy this favorable tax treatment. This fact, combined with the general complexity of such trusts and the rules surrounding them, make it advisable to consult with a qualified attorney if you are considering using these types of trusts as part of your estate planning.