27 Mar Two Alternative Tax Savings Strategies for Investment Properties
Strategy #1 – Deferred Sales Trust
How many times have you heard, or made these comments?
“If I sell my property I am going to get killed with taxes?”
Those of us who own highly appreciated assets such as homes, commercial real estate and businesses, are often reluctant to sell that asset because of the capital gain tax and depreciation recapture costs associated with the sale. There is a perfectly legal way to defer capital gains tax and reduce your overall tax burden. The Deferred Sales TrustTM can provide a way out.
“It would be better to let my kids inherit my assets at a stepped up value when I pass away.”
Sound too familiar? Most people don’t realize estate taxes are almost 50% above varying exemptions, and that non-spousal “step-up” values are set to cap at $1.3M in 2010!
There is a smart, functional, and legal way to address these issues. The answer may lay with a powerful tax tool called the Deferred Sales Trust.
If you own a business or real estate with a large amount of gain and are not selling your property because of capital gain taxes, or can’t find suitable, qualified property exchanges, then you may want to consider a Deferred Sales TrustTM (DST).
The DST utilizes a legal and established method that allows the seller of the property to defer capital gain taxes due at the time of sale over a period of time that is selected by the Seller/Taxpayer in advance.
Deferring taxes, legally, is not new. Some commonly used tax deferral methods include 1031 exchanges, charitable trusts, and traditional seller carry-back installment sale contracts.
Trust law predates the formation of the U.S. law and tax law. Various types of trusts are used by millions of Americans in order to protect and preserve their wealth for themselves and their heirs.
The DST can be used with any kind of entity, e.g., LLCs, S or C election corporations, as well as individuals who own real estate, rental properties, vacation homes, commercial properties, hotels, land, industrial complexes, retail developments, and raw land, to name a few.
What Are Long Term Capital Gains Taxes?
Long-term capital gains tax is simply defined as the tax we pay on the profit we make when we sell a capital asset we’ve held for a year or more. Capital Gains Tax is calculated by subtracting what you paid for the asset from the net selling price. The current long-term Capital Gains Tax rate for a capital asset owned for one year or longer is 15% for Federal taxes. Most states charge 5% to 10% on top of that (CA is 9.3%), making the total tax run as high as 25%. If there was depreciation taken on the asset, the cost basis is lowered by that amount, thus increasing the taxable gain!
Even with your primary residence, factoring in your tax exemption of $250,000 each for husband and wife, you may still have a hefty tax surprise when you sell your property and in the form of Capital Gains Taxes.
That isn’t the end of the story for the total tax effect though. Capital gain is added to the taxpayer’s adjusted gross income (AGI). This may raise the “floor” above which one can take a number of itemized deductions and effect, consequently, the Alternative Minimum Tax.
This could result in a large decrease or total loss of those deductions. This makes the effective, but hidden capital gain rate much larger than the stated federal and state rates. And, of course, tax payment obligations would begin immediately.
To make matters worse the capital gain and depreciation recapture taxes must be paid in the following tax quarter after the sale of the asset.
How Does the Deferred Sales Trust work?
The process starts with a property owner, “Seller/ Taxpayer”, selling ownership of the property/ capital asset to a dedicated trust (the “Trust”) that is set up specifically for the Seller/Taxpayer and the contemplated transaction.
Next, the DST Trained and Approved Trustee of the trust pays the Seller/Taxpayer for the property/capital asset. The payment isn’t in cash, but with a special payment contract called an “installment sales contract”. It is strictly a private arrangement between the trust and the Seller/Taxpayer. The term of payment is established in advance and pursuant to the installment sale contract negotiated by and between the Seller/Taxpayer and the DST Trained and Approved Trustee.
The payments may begin immediately or they may be deferred for some period of months or years.
The Trust then sells the property. There are zero Capital Gains Taxes due to the Trust on the sale since the Trust “purchased” the property for what it sold it for to a third party Buyer.
The Seller/Taxpayer is not taxed on the sale since he has not yet received any cash for the sale. Often Seller/ Taxpayers will choose deferral because they have other income and don’t need the payments right away. Of course, the payments may begin immediately.
Deferral is strictly an option. It is important to understand that payment of the capital gain tax to the IRS is done with an “easy installment plan” as the Seller/ Taxpayer receives the payments. Part of the payment received is tax-free return of basis, part is return of gain which is taxed at capital gain rates, and part is interest.
On top of that the tax payments will be made with depreciated dollars. The tax dollars will likely be worth less than they are today due to inflation. If invested properly, the money in the trust could potentially grow at a greater rate than that of inflation and even the distribution rate and ensures the necessary liquidity to pay back the note due to the Seller/Taxpayer. (The interest rate in the note to you is dictated by the IRS to be a competitive rate, i.e., 6% to 10%.)
While we have primarily focused on Capital Gains Tax, the amount of gain due to straight line depreciation is also deferred with a DST. But if you have taken accelerated depreciation in excess over straight line, this amount is not deferrable.
There is proper diversification by the DST Trained and Approved Trustee in investing the DST’s funds. The DST Trained and Approved Trustee may invest in REIT’s, bonds, annuities, securities or other “prudent investments” that are suitable to help assure the Trustee’s performance in repaying the Seller/Taxpayer pursuant to the held installment sales note. The DST Trained and Approved Trustee’s reinvestment of the proceeds may result in more or less risk depending on the nature of where the proceeds are reinvested.
The primary requirement of the trust’s investment objective is simply to produce the cash ow necessary for the scheduled installment sales note payments to the Seller/Taxpayer.
There are significant benefits to a Seller/Taxpayer in electing to use the DST when selling their property/ capital asset:
1. Tax Deferral: When appreciated property/capital assets are sold, capital gains tax on said sale is deferred until the Seller/Taxpayer actually receives the payments.
2. Estate Tax benefits: Accomplishes an “estate tax freeze” for estate tax purposes.
3. Maintains Family wealth: When properly structured, the principal inside the subject installment sales note can be preserved with “interest only” or partial principal payments creating the potential to pass on a large portion of the note principal to your legal heirs with proper estate planning.
4. Estate Liquidity: Converts an illiquid asset into monthly payments.
5. Retirement income: Provides a stream of income that can be used as retirement income.
6. Probate avoidance: With proper estate planning.
7. Eliminates Risks associated with Ownership: By utilizing the DST, you have taken an asset that is otherwise “exposed” or liability prone and converted it to a “no-liability” asset.
Nothing is given away to charity as happens with the competing strategy known as a Charitable Remainder Trust.
The DST allows all the principal and accrued interest to be paid to the Seller/Taxpayer via a custom prepared installment sales note, whereas the Charitable Remainder Trust pays income (interest) only. The DST has the potential to yield more bottom line dollars to the property/capital asset Seller/Taxpayer than the Charitable Remainder Trust.
The DST has the ability to generate substantially more wealth over the long run than a direct and taxed sale. it may be superior to the Charitable Remainder Trust, installment sale or like-kind property exchange in many respects. Consult your tax advisor to ascertain the potential bene ts of this option.
Frequently Asked Questions
Q. How can I know the amount of my payments from the trustee?
A. The payments are what you, the Seller/Taxpayer, desire and pre-negotiate with the DST Trained and Approved Trustee. Depending on your income goals and other objectives, the amount and length of term of the installment sales note are your choice.
Q. What happens if I die?
A. With proper estate planning (i.e., by creating a Living Trust) scheduled installment note payments otherwise due to you can continue to pay to your legal heirs pursuant to the note term that you have chosen.
Q. Are there any flexibilities or variability in the payment stream, such as increasing the payments over time?
A. Yes. The DST Trained and Approved Trustee, in his/her ab- solute discretion, may allow you to re nance your installment sales note in order to extend or shorten the note term or to provide you with payments (or greater payments) of principal (and should you decide to take an “interest only” note initially).
Q. Can i cancel the whole deal after a few years and get my money?
A. If the DST Trained and Approved Trustee deems appropriate, He/She may elect to terminate the installment sales contract. However, you would immediately owe all the taxes, including all unpaid capital gains due from the original sale of the property/capital asset.
Q. What happens if capital gain tax rates are changed after i set up the DST?
A. Politicians, from time to time, discuss changing capital gain rates. If that happens you would pay the new rate on the capital gains portion of your installment note payment. However, there is usually adequate notice to make a sound financial decision.
Q. Can i use my installment sales note to get back into real estate?
A. Yes, please contact the a duly qualified DST tax professional to discuss this option. We recommend professional advisors who are experienced in trust law, trust asset management and tax law.
Q. When the trust sells the property may I keep some of the cash from the sale?
A. Yes, in that case you would pay taxes only on the capital gain portion of the money which you kept for yourself outside the trust.
Q. How can I have my tax advisor or attorney analyze the DST strategy?
A. For detailed technical information, have your CPA contact EPT for a full legal and tax cite package. The names Deferred Sale TrustTM and DST are common law trademarked names and are not found in the code. All of the legal and tax authority used in the DST are in the tax code.
IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.
Strategy #2 – Upstream Beneficiary Special Power of Appointment (UB-SPOA) Trust
- Property may be placed in trust in a manner so that, when an elderly relative dies (a.k.a. the Upstream Beneficiary, or “UBER”), appreciated property will receive a tax-free basis step-up to fair market value. This may result in six or even seven-figure capital gains tax savings when property is later sold. Assets may be contributed by someone of the younger generation other than the UBER, and after the UBER’s death, may be used for the grantor or his family’s benefit.
- The most flexible and lowest-maintenance trust that may be used to realize these tax savings is called the “UB-SPOA” trust. Unlike with many other trusts, funding and administering this trust does not require making a taxable gift, filing a gift tax return, or filing trust income tax returns. If assets are first contributed to an LLC, then the LLC may be placed in trust, with the trust grantor or another individual as its manager.
- The step-up occurs as a result of granting a “testamentary general power of appointment” (“TGPOA”) to the UBER. This is a power the UBER may use, only with consent of the trust’s Protector (a trusted person, who may not benefit from trust property), that would allow him to direct the disposition of appreciated trust property under the terms of his Will. The UBER need not use the power for the step-up tax benefit to be realized.
- Although unlikely in any event, to avoid the UBER’s TGPOA from being deemed a sham, the ideal UBER would be an older family relative (as opposed to a stranger), and would be a discretionary beneficiary of the trust, so as to potentially receive at least a modicum of benefit from the arrangement.
- Assets may be contributed to an “incomplete gifts” trust (such as the UB-SPOA trust), which means no taxable gift occurs and no tax return need be filed. However, to avoid planning uncertainties I recommend upon the UBER’s death, stepped-up assets be distributed to the grantor’s spouse, either outright or in a limited liability company, which the grantor or another person may control. Property should be titled in only one spouse’s name prior to funding this trust, and upon funding the UBER should live at least 1 year to ensure the basis step-up occurs.
- Up to about ~$5 million of property may be stepped-up in trust. This amount will double if the GOP tax bill passes with its current provisions regarding the estate tax exemption. The amount that may be stepped up is equal to the UBER’s unused estate tax exemption, which is the estate tax exemption, minus the UBER’s taxable estate value, minus the value of any lifetime taxable gifts. The estate tax exemption for 2018 is $5.6 million, unless doubled under the GOP tax bill.
- The UB-SPOA trust has legitimate asset protection and estate planning benefits in addition to achieving basis step-up of trust property when the UBER dies. This arrangement is best implemented as part of an overall estate plan.
In 2013, Congress permanently raised the estate tax exemption to $5 million per person, or $10 million per married couple. The exemption is indexed annually for inflation, with a $5.6 million exemption for 2018. This higher exemption means less than 2% of all estates are expected to pay estate tax. What’s more, the GOP/Trump tax bill, which is likely to be made law, doubles the estate tax exemption to over $11 million per person.(1) Consequently, estate planners are shifting their focus from reducing estate tax liability to optimizing the tax-free basis step-up of assets upon an individual’s death. Upstream Optimal Basis Increase (UOBI) strategies represent the cutting-edge of such planning. Essentially, assets held in trust may be stepped-up once an elderly beneficiary dies (called an “upstream beneficiary” or “UBER”) up to their unused estate tax exemption amount. This will happen even if the UBER is not the trust’s grantor. This means assets contributed to a trust by a younger generation will be stepped-up when an UBER dies, with assets remaining in trust and available for younger beneficiaries. For an elderly beneficiary with a modest or moderate net worth, assets subject to the step-up may exceed $5 million, which could result in very substantial capital gains tax savings. This article examines one way to achieve UOBI benefits: the Upstream Beneficiary Special Power of Appointment Trust (UB-SPOA Trust) as well as certain do’s and don’ts associated with UOBI planning.
The Internal Revenue Code § 1014 Basis Step-Up Upon an Individual’s Death
“Basis” is a value assigned to property to calculate capital gains tax. Basis is typically the price property is bought for. When property is sold, tax is levied on the difference between the sales price and the property’s basis. So if property is bought for $100,000 (its basis) and sold for $250,000, capital gains tax on the difference ($150,000) is due. Upon its sale, the property’s basis is adjusted to the purchase price with respect to the purchaser. In this instance, the new basis post-sale would be $250,000, or what the purchaser paid for it. Yet there is another way to increase basis. Under section 1014(a) of the Internal Revenue Code (“IRC”), if a person dies, his property generally receives a tax-free “step-up” in basis to its fair market value (“FMV”) at time of death. (2) This means capital gains tax is eliminated on appreciated property, if sold by its heir immediately upon receiving it, or future capital gains will be calculated according to the difference between the future sales price and the stepped-up basis.
EXAMPLE 1: The original purchase price of an asset is $400,000. If the asset were later sold in its entirety for $1 million with no basis step-up in the interim, then capital gains tax would be assessed on $600,000 of appreciation. Long-term federal capital gains tax can be as high as 23.8%, and state tax may also be levied. At the highest federal-only rate, the tax due would be $142,800.
EXAMPLE 2: The original purchase price of an asset is $400,000. Its owner dies, and the asset’s FMV at such time is $1 million. Accordingly, the basis “steps-up” to $1 million. If the property’s heir sells the asset for $1 million, he would pay no capital gains tax, saving $142,800 in taxes, due to the tax-free basis step-up. If the heir later sells the property, after further appreciation to $1.1 million, he would pay capital gains tax on only $100,000 of appreciation, being the difference between the sales price and the new stepped-up basis. If he sells the asset for $900,000, he would recognize a loss of $100,000, which results in no tax due and which may be used to offset tax on other gains.
UOBI Planning for Tax-Free Basis Step-Up of Property During One’s Lifetime
UOBI planning allows us to apply the IRC § 1014 basis step-up, as illustrated in Example 2, to a younger generation’s assets after transfer to a trust, when an “upstream” relative from the older generation dies. The legal foundation for this is established by the fact that if a power, called a “testamentary general power of appointment” (“TGPOA”), is given to an individual, then when he dies the assets subject to the TGPOA will be included in his gross estate, even if the power is never used. (3) Assets included in one’s gross estate by way of a TGPOA will receive a basis step-up upon the power holder’s death, regardless of whether the power is exercised. (4)
A TGPOA is a provision of a trust that allows a person to direct the disposition of certain trust assets at death by leaving appropriate instructions in a Will or codicil. This power is valid even if it may be used only with consent of another person (called a trust “Protector”). (5) If the Protector never consents to use of the power, or the UBER never attempts to use the power, then assets remain in trust the entire time yet still receive a step-up upon the power holder’s death.
Of course, we wouldn’t want the TGPOA to cause adverse tax consequences. For example, we wouldn’t want so much property to be subject to a TGPOA that the power holder’s estate exceeds his estate tax exemption, resulting in estate tax liability. Furthermore, we wouldn’t want depreciated property to be subject to a TGPOA, as this would cause a “step-down” of such property (basis adjustment to a lower value) upon the power holder’s death. Fortunately, it is acceptable to carefully craft a TGPOA so that depreciated assets, or excess assets that would cause estate tax liability are not subject to the power and thus not includible in the power holder’s gross estate.
The UB-SPOA Trust
The UB-SPOA Trust is an irrevocable, incomplete gifts grantor trust with a Special Power of Appointment (“SPOA”) and UBER TGPOA. Let’s examine all but the last of these descriptive terms.
- “Irrevocable” means the trust’s grantor (the person who funds the trust) has no right to demand a return of trust property, neither may he amend or revoke the trust, however the trustee or others may amend the trust if the trust agreement allows.
- “Incomplete gift” means despite not having the right to a return of property, the grantor retains certain rights over disposition of trust property (i.e. who gets the property when transferred out of trust). (6) If a gift is incomplete, then no gift tax liability is triggered, neither must a gift tax return be filed.
- The grantor retains certain other powers over trust property so that he is also owner of the trust for income tax purposes.(7) This type of trust is referred to as a “grantor trust” and all trust income is taxable to the grantor. A grantor trust need not file its own tax return.(8)
- A Special Power of Appointment (“SPOA”) is a power to appoint trust property to anyone besides the power holder, his estate, his creditors, or creditors of his estate. Unlike with a general power of appointment (“GPOA”), where one may appoint assets to himself, his estate, his creditors, or creditors of his estate, holding a SPOA does not cause inclusion in one’s estate. Exercising a SPOA will cause an incomplete gift to become complete and thus subject to gift tax, unless the gift is less than the annual gift tax exclusion,(9) except using a SPOA to return property to a trust’s grantor is not a gift, and using a SPOA to transfer property to the grantor’s spouse is not a taxable gift.
Although it must be drafted carefully and with skill, the UB-SPOA trust is the simplest arrangement that allows for a legitimate step-up of appreciated assets contributed by someone from a younger generation when the UBER dies. Funding the trust via incomplete gift means trust property need not be appraised in order to file a gift tax return. Trust income is reported on the grantor’s tax return as if he held the property directly, with no trust tax return needing to be filed. Trust property is also protected, barring fraudulent transfers, from creditors of the trust’s grantor or beneficiaries. The trust is also a legitimate estate planning tool that may be used to provide for loved ones, as well as meet certain estate succession goals.
UOBI Planning Uncertainties and How to Avoid Them
As a general rule, granting a carefully crafted TGPOA results in a tax-free step-up of appreciated property subject to the power when the power holder dies.(10) However, there are a few exceptions to this rule, and there are also some “gray areas” where it’s not completely clear whether a step-up would occur. First we’ll identify the exceptions and gray areas, and then we’ll examine how to avoid or mitigate them. They are as follows:
- If the UBER holds a TGPOA 1 year or less before dying, and property then passes back to a trust’s grantor or his spouse, then assets in some circumstances may or may not be stepped-up.(11) The doctrine of step transactions is applicable here and thus should also be considered.
- Property in an incomplete gift UB-SPOA trust will likely receive the step-up, but without precautionary measures there remains a modicum of uncertainty as to the step-up, and without careful planning the step-up will be reduced by the amount of depreciation and similar deductions taken against property prior to the UBER’s death. Fortunately, this uncertainty and potential for step-up reduction is avoided if a gift is completed upon a power holder dying without exercising his TGPOA. A completed gift to a spouse, with property being distributed outright or in an LLC, is the easiest way to accomplish this.
- If a TGPOA were granted to a complete stranger with no estate planning context, and without making the power holder at least a nominal beneficiary, the arrangement may be deemed a sham.
- If a trust beneficiary is also a trustee with a right to distribute to himself, or the sole trustee, then upon UBER’s death only half the step-up benefits under § 1014(a) may be realized.(12) Therefore we should avoid having a beneficiary as trustee.
IRC § 1014(e) and the 1 Year Property Reacquisition Rule; Step Transactions
Some may view UOBI planning as exploiting an unintentional loophole in the tax code. On the contrary, IRC § 1014(e) shows Congress has already considered planning of this nature. § 1014(e) helps clarify when such planning is permissible. § 1014(e) does not remove all uncertainty in some instances, but as we’ll soon discuss, these uncertainties may be avoided with proper planning. An excerpt of § 1014(e) is as follows:
“If – (A) appreciated property was acquired by the decedent by gift during the 1-year period ending on the date of the decedent’s death, and (B) such property is acquired from the decedent by (or passes from the decedent to) the donor of such property (or the spouse of such donor), the basis of such property in the hands of such donor (or spouse) shall be the adjusted basis of such property in the hands of the decedent immediately before the death of the decedent.”(13)
A strict reading of the above indicates that, only an outright gift, or a completed gift to a trust with a TGPOA (or other general power of appointment) would be subject to § 1014(e). After all, an incomplete gift to a trust is by its very definition not a gift to the decedent,(14) despite his holding a TGPOA which would cause inclusion of property in his gross estate. In this context, if the UBER dies without exercising or releasing his power, then no gift to or from the UBER has occurred at any time.(15) A completed gift to a trust, however, with an UBER TGPOA or other general power of appointment or right of withdrawal constitutes a gift to the power holder.(16)
A strict reading of § 1014(e), then, would lead us to believe that an incomplete gift to a UB-SPOA trust would receive a step-up of appreciated assets, even if the UBER held a TGPOA less than 1 year, since § 1014(e) only applies to assets acquired by a decedent by gift. Likewise, selling an asset to a trust would preclude application of § 1014(e). Only a completed gift to an UB-SPOA trust would be subject to the statute. Furthermore, if an asset were transferred to someone other than the trust’s grantor or his spouse, either through exercising the TGPOA or through making a default disposition in the event an UBER dies without exercising his TGPOA, then § 1014(e) will not prevent a basis step-up of appreciated property.
However, there is another pitfall we should be aware of: the step transaction. A step transaction is a series of closely related and interdependent transfers, usually which happen in a short timeframe, which may be disregarded as being separate in some instances.(17) § 1014(e) is Congress’ addressing the step transaction with regards to § 1014(a). Essentially Congress is saying that if you gift an appreciated asset to a person, then if the recipient dies within 1 year and the asset is reacquired by the donor or his spouse, a step-up will not occur.(18) Clearly this statute is intended to prevent gifts to someone on his deathbed solely to benefit from the tax-free step- up. The upshot, however, is that if a person acquires appreciated property and dies more than 1 year later, a basis step-up will apply even if assets then pass back to the original donor. What this means is, if the IRS challenges a strategy as a step transaction not subject to § 1014(e) (such as the incomplete gifts UB-SPOA strategy), it will be almost impossible to invalidate the step-up if the UBER held the power for at least 1 year before dying. After all, Congress already addressed one type of step transaction under § 1014(e), and gave their blessing to a step-up so long as the recipient holds the property at least 1 year prior to death. Furthermore, there are other measures we can take to defeat a step transaction argument. For example: if all parties to an alleged step transaction do not have knowledge of or agree to an end result, then the “intent test” of step transaction doctrine won’t apply. With regards to an UBER TGPOA, the UBER does not have to be informed of the reasons for giving him a TGPOA. He need not even be told he has the power!(19) In conclusion, granting an UBER a TGPOA at least 1 year prior to his death is not an absolute requirement for achieving basis step-up of appreciated trust property, unless the trust is funded via completed gift. The § 1014(e) 1 year rule instead provides us a “safe harbor” that ensures the step transaction doctrine won’t apply to UOBI planning that’s not otherwise subject to § 1014(e).
UOBI Planning and Incomplete Gift Trusts
If an appreciated asset is transferred to an UB-SPOA or other trust via incomplete gift, it will probably be stepped-up upon an UBER’s death regardless. However, some uncertainty may exist with the arrangement unless we take precautions. To understand this better, let’s read an excerpt from federal regulations regarding basis step-up upon the death of the holder of a power of appointment:
“[Property that receives a basis adjustment under IRC § 1014(a)] includes property acquired through the exercise or nonexercise of a power of appointment where such property is includible in the decedent’s gross estate.”(20)
The word we’re concerned with here is “acquired”. If a grantor gifts property to a trust with strings attached (an incomplete gift), could you say the grantor “acquired” an asset that he already had in the first place? The regulations seem to be favorable in this regard. Another excerpt from the same regulation says:
“Property acquired prior to the death of a decedent which is includible in the decedent’s gross estate… such as… property held by a taxpayer and the decedent as joint tenants, is within the scope of this paragraph [and will be stepped-up under IRC § 1014(a)]” (21)
Accordingly, one might think the worst-case scenario is if an asset is subject to an UBER’s TGPOA for less than one year, then it might not be stepped-up under a very broad interpretation of IRC § 1014(e), yet there is another excerpt from the statute corresponding to the foregoing regulation that concerns us, namely:
“…if the property is acquired before the death of the decedent, the basis shall be the amount determined under subsection (a) [meaning appreciated property will be stepped-up] reduced by the amount allowed to the taxpayer as deductions in computing taxable income… for exhaustion, wear and tear, obsolescence, amortization, and depletion on such property before the death of the decedent.” (22)
The foregoing seems to indicate that appreciated property transferred via incomplete gift to a trust with an UBER TGPOA will receive a step-up when the UBER dies, even if it’s deemed that the grantor still ‘owns’ the property because the gift was incomplete (and thus he didn’t “acquire” it upon the UBER’s death, but rather had acquired it beforehand), but depreciation deductions taken on the property prior to the UBER’s death will result in a reduced step-up. To avoid this, I recommend a trust be drafted so that there is a default recipient, other than the grantor, who receives property if and when the UBER dies without exercising his TGPOA. This recipient would not have acquired or jointly owned property before the UBER’s death, since he is acquiring property for the first time, or at the very least had not possessed the property (jointly or otherwise) prior to the UBER’s death while the property was in trust. This will avoid any uncertainty (however remote) surrounding the word “acquired” in the aforementioned regulation, as well as avoid the step-up being reduced by depreciation deductions prior to the UBER’s death.
Distributing property from an incomplete gifts trust will, of course, complete the gift. A completed gift is taxable, unless the recipient is the spouse of the grantor, in which case the gift would be tax-free, with no gift tax return filing needed. § 1014(e) uncertainties won’t be an issue so long as the UBER TGPOA is in effect for at least 1 year prior to his death. If one doesn’t wish the recipient-spouse to manage the property upon receipt, it could be placed in an LLC owned by the trust, with the grantor or another person as LLC manager. So long as the LLC is taxed as a disregarded entity, or a partnership with an IRC § 754 election, the § 1014(a) basis step-up will apply to LLC property.
Drafting a Trust so the UBER TGPOA is Not Deemed a Sham
The IRS has on several occasions challenged general powers of appointment where the power holder was a remote or “contingent” beneficiary (i.e. he could eventually be but was not presently a beneficiary).(23) Case law has repeatedly been decided in favor of the taxpayer in such instances, nonetheless we caution against giving a TGPOA to a complete stranger. Likewise we caution against a “naked” power that is not coupled with at least a nominal beneficial interest. Making an UBER a discretionary beneficiary, where the trustee may but need not make distributions to him, should be adequate to ensure the TGPOA is valid.
UOBI planning allows for tax-free basis step-up of appreciated property when an elderly loved one dies. The UB-SPOA trust is the most flexible and least cumbersome vehicle for realizing this as well as asset protection and estate planning benefits. Nonetheless it must be implemented with precision and skill.
(1) As of December 5, 2017, both House and Senate versions of the tax bill have been passed. Although there are differences between each version, both versions double the estate tax exemption while preserving the basis step-up of a dccedent’s property under IRC § 1014.
(2) Conversely, under IRC §1014(a) an asset that has depreciated would receive a step-down to fair market value, unless measures are taken to avoid such.
(3) Title 26 U.S.C., § 2041 (a)(2).
(4) Title 26 U.S.C. § 1014(b)(9). See also 26 CFR 1.1014-2(b)(2), which states in part that assets to which the step-up applies “…includes property acquired through the exercise or nonexercise of a power of appointment where such property is includible in the decedent’s gross estate.”
(5) For our purposes the Protector must not have any present or future beneficial interest in or use of enjoyment of trust property (unless the trust is compensated at FMV for use of its property). See Title 26 U.S.C., § 2041(b)(1)(C).
(6) 26 CFR § 25.2511-2(b).
(7) Title 26 U.S.C. §§ 671-679
(8) However, see IRS form 1041 instructions, p. 13, regarding Optional Method 1. This method requires the trustee to issue a statement to the grantor regarding items of trust income or loss, so that the grantor may file an accurate tax return. This statement is not sent to the IRS.
(9) The annual gift tax exclusion is $14,000 for 2017, and $15,000 for 2018.
(10) See supra note 3.
(11) Title 26 U.S.C. § 1014(e).
(12) Title 26 U.S.C., § 2041(b)(1)(C)
(14) Supra note 6.
(15) Supra note 6; Title 26 U.S.C. § 2514(b),(e).
(16) Crummey et al. v. Commissioner of Internal Revenue, 397 F.2d 82, (9th Cir.1968). Note that if multiple persons have a right of withdrawal or general power of appointment over the same property, then equal fractional gifts shall be deemed to have been given by each of them, and each power holder will have a corresponding inclusion in their gross estate. See Title 26 U.S.C. § 2514(c)(3)(C).
(17) Gregory v. Helvering, 293 U.S. 465 (1935).
(18) Note that § 1014(e) only prevents basis step-up of property. It does not prevent a step-down of depreciated property.
(19) For an excellent case law analysis and overview of step transactions as applied to UOBI planning, see The Optimal Basis Increase and Income Tax Efficiency Trust, Edwin P. Morrow, III, J.D., LL.M. (tax), pp. 119-120 (2017), as found on https://www.ssrn.com/en/.
(20) 26 CFR 1.1014-2(b)(2).
(22) Title 26 U.S.C. § 1014(b)(9).
(23) Cristofani v. Commissioner, 97 T.C. 74 (1991); Kohlsaat v. Commission, T.C. Memo 1997-212 (1997).