One of our most powerful estate planning tools is the ability of principal owners of assets including real estate to transfer appreciated assets to their survivors and heirs at time of their passing at then current market values. Often referred to as a “step-up in basis,’’ the ownership of appreciated assets can generally be passed on without capital gains tax liability.1
In March 2023, the IRS issued Revenue Ruling 2023-2 which eliminates a step-up in basis for assets held in an irrevocable trust that are passed on to survivors and heirs.2 Before discussing further details of the ruling, lets first review several basic trust concepts.
Revocable Trusts Versus Irrevocable Trusts
Revocable trusts (aka living trusts) can be changed at any time prior to the death of the person(s) who created the trust (aka the grantor), provided they remain mentally competent. We have previously written a blog on the benefits of trusts3 which include:
- Avoidance of probate
- Asset protection
- Privacy of trust details
- Incapacity planning
- Control over how beneficiaries will participate in inherited assets
Once created, irrevocable trusts cannot be changed during a grantor’s lifetime. The grantor of the irrevocable trust relinquishes all ownership rights to the assets into the trust.4
Irrevocable trusts are generally created to save estate taxes, gain access to government benefits that have income or net worth limitations, and to safeguard assets from legal judgements.
Implications of IRS Revenue Ruling 2023-2
Until this ruling was issued, the IRS had not provided guidance that disallowed beneficiaries of irrevocable trusts to receive a step-up in basis on inherited assets. As a result, beneficiaries generally were able to avoid capital gains taxes and were not deemed to be in violation of the tax code.
In issuing 2023-2, the IRS reasoned that the assets that are transferred to the irrevocable trust are essentially gifted to the trust and transferred at a value equal to the grantor’s basis in the transferred assets (original cost less depreciation plus capital improvements) at the time the trust is first created. As previously written in a recent blog post5, recipients of gifts acquire those gifts at a value equal to donors adjusted basis – and will be responsible for paying full capital gains when they choose to sell the asset.
Assets that are gifted and no longer in possession of the donor and are therefore not eligible for step-up in basis when the donor passes.
Deferring Taxes on Investment Properties Held in an Irrevocable Trust
While beneficiaries who inherit appreciated assets such as equities, collectables, and personal real estate held in an irrevocable trust, we recommend that beneficiaries who inherit appreciated real estate investment properties seek the advice of knowledgeable tax advisors to determine if related capital gains can be deferred via a 1031 exchange.
Irrevocable Trusts and DSTs
Per IRS Revenue Ruling 2004-86, properties structured as a Delaware Statutory Trust (DST) can be eligible to qualify as 1031 exchange replacement property options6. Readers of our past blogs should be aware that the option to invest in DSTs is limited to accredited investors which generally must have a minimum net worth of $1 million excluding equity in their personal residence or an annual income of $200,000 if single of $300,000 if married.
Investors who are selling investment properties held in an irrevocable trust must generally meet higher and more stringent accredited investor qualifications to invest in DSTs:
- The irrevocable trust must have a minimum of $5 million in assets, or
- The trustee or co-trustee of the trust is a bank, insurance company, registered investment company, business development company, or small business investment company, or
There may be other criteria based on specific circumstances which should be evaluated by a qualified tax advisor.
Virtually all the tax benefits that we as real estate investors receive rely on federal and state tax codes. For clients who inquire about whether certain current tax benefits will be in effect in future, our general response has been “What the government gives, they can take away.” Meaning that we all need to remain vigilant to any pending or already enacted tax changes that could impact our investment and estate planning strategies.
Please contact us for more information on tax advantaged real estate investments and for referrals to tax and estate planning specialists.
1 Transfer of assets upon death that exceed $12.92 million (single person) or $25.84 million (married couple) can be subject to estate taxes.
4 It may be possible to modify irrevocable trusts by designated beneficiaries or a judge’s approval.