Contributed by: Brian W. Sak, CFP, CLU, ChFC

For high-net-worth individuals, preserving family wealth across generations often involves balancing two competing priorities: minimizing estate taxes and maximizing the capital gains tax benefits through a basis adjustment. These two objectives frequently intersect, particularly when deciding whether to leave assets in an estate or transfer them into a trust. Each strategy has its merits, but understanding the implications of both is essential to making informed decisions.

The Cost Basis Adjustment: A Powerful Tool for Heirs, But with a Trade-Off

The basis adjustment refers to the adjustment of an asset’s cost basis to its fair market value on the date of the original owner’s death. This recalibration can significantly reduce or even eliminate capital gains taxes when the asset is sold by heirs.

Example:
Suppose a property purchased for $500,000 grows to a value of $2 million by the time of the owner's passing. If the asset is inherited and subsequently sold for $2.1 million, the heirs would only pay capital gains tax on the $100,000 appreciation above the stepped-up basis of $2 million. Without the step-up, the taxable gain would have been $1.6 million ($2.1 million minus $500,000).

This tax benefit makes retaining assets within the estate an attractive option for many families. However, this approach has two potential drawbacks:

1. The total value of the estate, including these appreciated assets, may be subject to federal estate tax.
2. Any assets that are at a loss at the time of passing will receive a basis adjustment downward to fair market value.

Estate Tax: The Cost of Wealth Transfer

For 2025, the federal estate tax exemption is $13.92 million per individual ($27.84 million for married couples with proper planning). Estates exceeding these thresholds are taxed at rates up to 40%. While this exemption is historically high, it is set to sunset in 2026, reverting to approximately $6 million per individual adjusted for inflation, unless new legislation is enacted.

Example:
If an individual passes away with an estate worth $20 million in 2025, the taxable portion of the estate would be $6.08 million ($20 million minus $13.92 million). This could result in an estate tax liability of $2.432 million, significantly reducing the wealth transferred to heirs.

This risk often leads individuals to explore strategies like transferring assets to trusts, which can help reduce estate tax exposure but may eliminate the step-up in basis.

Making Transfers to Trusts: Reducing Estate Tax Exposure, But with a Trade-Off

Transferring assets to an irrevocable trust during one’s lifetime removes them from the taxable estate, shielding their future appreciation from estate taxes. However, assets in an irrevocable trust typically do not receive a step-up in basis upon the grantor’s death. Instead, the heirs inherit the original cost basis, increasing potential capital gains tax liability upon sale.

Example:
If the $500,000 property from the earlier example is transferred to a trust and grows to $2 million, heirs selling it for $2.1 million would owe capital gains tax on $1.6 million ($2.1 million minus $500,000), as the basis adjustment is forfeited.

While trusts can mitigate estate taxes, the capital gains tax burden may offset some of the savings, particularly for highly appreciated assets.

Finding the Right Balance: Strategic Considerations

There is no one-size-fits-all solution when weighing the benefits of the basis adjustment against estate tax exposure. A successful strategy requires a tailored approach, considering your financial goals, the nature of your assets, and your family’s long-term priorities.

Key Strategies to Consider:

• Transfer Assets Likely to Appreciate: Assets with significant growth potential are strong candidates for transfer to trusts. By removing these assets from your taxable estate, you can shield future appreciation from estate taxes.
• Retain Low Basis Assets in the Estate: To maximize the step-up in basis, assets with a low basis can be retained in the estate. This ensures heirs benefit from minimal capital gains tax exposure upon the sale of these assets.
• Preserve Flexibility Through Asset Substitution: Having the ability to substitute low basis assets held in a trust with high basis assets from the estate is a powerful strategy. For example, swapping assets that have already appreciated for those with minimal gains allows you to retain the step-up in basis for the low basis assets while protecting future growth from estate taxes.
• Leverage Lifetime Gift Exemptions for Funding: Consider funding PPLI policies or trusts with lifetime gifts under the $13.92 million exemption (per individual). This approach allows you to shift wealth out of the estate tax-free while setting the stage for long-term tax-efficient growth.
• Grantor Retained Annuity Trusts (GRATs): GRATs allow for the transfer of appreciating assets outside the estate while minimizing gift tax exposure. The original cost basis remains, but the asset growth escapes estate taxation.
• Using a Charitable Remainder Trust (CRT): For philanthropic individuals, a CRT can reduce estate taxes and provide an income stream to beneficiaries. Heirs do not receive a step-up in basis, but capital gains taxes may be completely avoided if structured properly.
• Life Insurance as a Wealth Replacement Tool: Irrevocable life insurance trusts (ILITs) can offset estate taxes or lost step-up benefits by providing tax-free liquidity to heirs at the precise time it is needed.
• Use PPLI to Enhance Flexibility and Tax Efficiency: Trust-owned PPLI assets are one of the very few areas of planning that allow for the effective mitigation of the loss of step-up in cost basis on trust-owned assets, while also avoiding estate tax on estate-owned assets.

Tailored Planning for Maximum Benefit

The decision to leave assets in an estate or transfer them to a trust is highly nuanced, and the optimal approach depends on individual circumstances.

Case Study Examples:

1. Real Estate-Focused Estate: A couple with a $25 million estate primarily consisting of real estate may choose to retain properties in the estate with significant unrealized gains to maximize the basis adjustment while using transfers to trusts for high basis assets to reduce estate tax exposure.
2. Business Sale Strategy: A business owner planning to sell their company may use a combination of GRATs and ILITs to shift future appreciation out of the estate while ensuring heirs have liquidity to cover any remaining tax liabilities.
3. PPLI-Focused Plan: An individual with a $30 million estate, including highly appreciated stocks and high basis positions, liquidates the high basis assets to fund a PPLI policy owned by an irrevocable trust. This minimizes immediate capital gains taxes while retaining low basis assets in the estate for a basis adjustment at death.
4. Philanthropic Approach: A philanthropically inclined family with $50 million in assets uses a CRT to transfer appreciated securities. Simultaneously, the family uses life insurance to replace the value of the donated assets for their heirs tax-free, ensuring their wealth legacy remains intact.

Conclusion

Balancing the benefits of the basis adjustment against the estate tax implications requires careful planning and a forward-thinking approach. At Granite Harbor Advisors, we specialize in crafting customized strategies that align with your unique financial objectives and family priorities. By working together, we can help preserve your legacy while navigating the complexities of estate and tax planning with confidence. If you’re ready to explore the best options for your situation, contact us today to schedule a consultation. Our team of experienced professionals is here to guide you every step of the way.