May 6, 2024
There are many ways to harness the step-up in basis while ensuring financial security — and avoiding many pitfalls.
By Mallon FitzPatrick
Wealth transfer starts with a comprehensive wealth plan to analyze the whole financial picture, including the balance sheet and cash flow. One goal of the transfer is to avoid humbly asking loved ones for funds to pay for expenses at any point. So, before gifting, it’s crucial to ensure that the wealth holder can maintain their lifestyle and cover healthcare costs throughout the remainder of their life, with a margin of safety.
The fear of giving up control and running out of money is understandable and is a pervasive concern among clients considering a transfer. There are several estate planning strategies to help overcome these fears; here is an article on the topic.
Also important is understanding what is on the table for transfer. Some possessions, typically homes or stocks with sentimental value, are cherished, and many avoid giving these assets away. After transfer objections are addressed and prohibited assets are understood, establishing a thoughtful asset location is a prudent next step.
Asset Location Strategy for Wealth Transfer
Asset location strategy is simple to understand and yet sometimes difficult to execute effectively. The step-up in basis — which which raises the cost basis of investments to the value on the date of death — can offer significant tax savings. A wealth holder is wise to leverage this ‘tax gift’ as much as possible. Individuals may pass more peacefully, knowing they avoided paying a large income tax bill. Only assets held by the deceased at death will receive a step-up in basis.
Assets with a low-cost basis and high unrealized gains are the most advantageous to hold before death. Assets with the least amount of unrealized capital gains and that are expected to appreciate significantly over time make the most sense to transfer before death. Transferring assets sooner allows investments to experience a longer period of growth, free of gift and estate taxes.
Sounds simple, right? One thing we all know about estate planning is that it’s never as simple as it sounds.
What to hold
First and foremost, ensure that the wealth transferor holds sufficient assets and liquidity to cover expected expenses, with surplus. Income-generating assets are good ones to hold, and those with high embedded gains are even better. In most cases, income-producing, low-basis assets are direct real estate investments or legacy stock positions that pay higher-than-average dividends. The transferor should keep these assets in the estate. Bonds generate income but typically lack significant capital gains.
Exercising ‘swapping power’
A wealth transferor gives themself added flexibility if they gift assets into an irrevocable grantor trust. Assets in these trusts are outside of the transferor’s estate, and the basis remains intact when the grantor passes. There is a wide variety of grantor trusts, but most, if not all, allow the grantor to swap assets within the estate for assets of equivalent value from the grantor trusts. By removing assets with significant gains from the trust and replacing them with assets with minimal capital gains from the estate, the grantor can ensure the assets receive a step-up in basis at death.
The grantor is required to pay the trust’s income taxes, so there is a cost associated to having the swap power. However, for those seeking to maximize the value of the assets outside of the estate while reducing the value of assets inside the estate, a grantor trust is a powerful tool. If the tax bill from the grantor’s trust becomes too large for comfort, the grantor may change the trust to a non-grantor’s trust. A non-grantor’s trust pays its own taxes, and the original grantor forgoes the ability to swap assets.
Increase Liquidity, Avoid Capital Gains, and Create a Safety Net
The ideal assets to keep in the estate, those with low-cost basis that generate income, often do not provide sufficient liquidity to cover expenses — or at least not enough to make the transferor feel comfortable. A common strategy to increase liquidity and avoid capital gains tax is leverage.
Mortgages and more
Leverage strategies typically employed include mortgages, home equity line of credits (HELOCs), and pledged asset lines against securities. Some transferors harness the power of leverage and make it a core tactic to fulfill their wealth transfer goals. Others see it as a safety net. Either way, the assets within the estate are stepped up at death and are used to pay down the loans.
Transferors may use HELOCs and pledged asset lines to convert assets into a stream of cash that they may draw upon when needed. The transferor may also take out a mortgage against real property to create a lump sum of cash for gifting. These strategies increase liquidity and preserve the ability to take advantage of the step-up in basis at death. The magnitude of success of any debt strategy depends on the interest rate environment and the growth of assets. Transferors should consider a careful cost-benefit analysis.
Life-Insurance Possibilities
Private Placement Life Insurance (PPLI) is a low-cost option that provides liquidity while avoiding sale of assets with low-cost basis. The policyholder can also invest in nearly any asset class and benefit from tax-free growth. PPLI policies are written to minimize the mortality and administration costs of insurance and maximize the amount of cash value that may be loaned to the policy owner. An owner requiring liquidity simply borrows against the cash value. Borrowing typically enables the owner to avoid selling positions they hold outside the policy.
At death, the policy pays the outstanding loan, and the remaining death benefit is transferred out of the estate, tax-free.
PPLI policies are not for everyone. Although they are low-cost, meaning their fees are relatively low, the premiums needed to initially fund an PPLI policy are high — roughly $3 million to $5 million in the first five years. Alternatively, lower barrier insurance products are available, such as standard whole and variable permanent policies. However, the mortality and administration costs for these products typically decrease the return on cash value, and the investment choices are limited.
Additional Trust Options
Sometimes a transferor resists using leverage or insurance, and prefers other sources of liquidity for transferring wealth. Some irrevocable trusts allow the grantor to indirectly (and, in some cases, directly) receive a distribution. Examples include the spousal lifetime access trust (SLAT), spousal lifetime access non-grantors trust (SLANT), and the domestic asset protection trust (DAPT).
Distributions on these trusts go to the grantor and the assets outside of the estate decrease, reducing the transfer exercise’s benefit. When maximum asset transfer and minimal estate tax are the goal, it’s best to view distributions as a safety net.
Powerful Strategies That Lose the Step-Up in Basis
One of the most popular wealth-transfer strategies is discount-valution gifting. The transferor establishes a family LP or a family LLC as a controlling partner or member and gifts the next generation a non-voting interest. The non-controlling interest is less marketable, and the value of the gifted shares or interest may be discounted by 20% to 40%. So the wealthholder may gift $10 million of assets yet only use $6 million of their lifetime exemption.
Like assets within an irrevocable trust, the gifted interest in the LP of LLC loses the step-in basis at death. The LP/LLC should own assets that have minimal gains but are expected to grow significantly.
House gifting: positives and pitfalls
Many clients ask us about gifting their primary residence. It is typically a sizable holding but relatively illiquid. Gifting a primary residence outright means that the recipient, often the next generation, immediately owns and controls the property. The cost basis is transferred with the property. If the home was purchased many years ago, it likely incurs a large unrealized gain and tax liability when sold.
Primary homes can be gifted through a qualified personal residence trust (QPRT). The senior member of the family (grantor) uses a portion of their lifetime exemption to gift the primary residence to a QPRT for the benefit of heirs, at a discounted value. This discount decreases the amount of exclusion used. For example, a $5 million home may be contributed to the trust and only use a $4 million exclusion. The grantor continues to live in the home for the remainder of the trust term, typically their lifetime or a set number of years.
Although this sounds like a good strategy to transfer a large, illiquid asset, there are several considerations. First, the grantor transfers the cost basis to the beneficiaries, so the estate-tax benefit of setting up the trust must outweigh the tax consequences of losing the step-up in basis. Other potential pitfalls include the gift-tax treatment of mortgage payments and the inability to use the property as collateral for future loans.
Instead of implementing a QPRT to transfer the value of the home outside of the estate, a transferor may consider a technique that preserves the step-in basis. Leveraging the primary residence and gifting the borrowed funds keeps the home within the estate, allowing it to benefit from a step-up in basis at death, and transfers much of the value to the next generation. This strategy works better in a low-interest rate environment.
Planning Should be Thoughtful … and Flexible
When considering a transfer strategy, it is important to understand the full financial picture and the current and future impact of income and estate taxes for both the transferor and the next generation. Before proceeding with any gifting strategy, evaluate important items like step-up in basis, preference for control, adequate cash flow and asset location.
A potential wealth transferor can benefit from consulting with a qualified wealth manager, as well as legal and tax professionals when contemplating these complex strategies. Whether the transferor has a few million or tens of millions of dollars, planning affords families the opportunity to customize a gifting strategy and create a legacy for generations to come.
Mallon FitzPatrick, CFP, is a principal and managing director at Robertson Stephens and heads the firm’s financial planning center. For more information about Mallon or Robertson Stephens, please visit www.rscapital.com or email info@rscapital.com. Advisory services are offered through Robertson Stephens Wealth Management LLC. Opinions presented are those of the author and not necessarily Robertson Stephens. Please read important disclosures.
