Transfer Assets to Spouse When Death Is Anticipated

Depending on your state and circumstances, transferring appreciated assets to a spouse expected to pass away may enable a full step-up in basis (upon death), eliminating capital gains tax.

Strategy Overview

Estate planning, by definition, involves developing a plan for your eventual death. As of 2024, when an individual passes away, the purchase price of an asset is reset to the value of the asset when one passed away (known as "step-up in basis"). Depending upon the state you live in, how the assets are held (individual; joint, etc.), and how long the assets are owned, transferring appreciated assets to the spouse who is anticipated to pass away first may allow the surviving spouse to benefit from a 100% step-up-in-basis, eliminating the prospective capital gains tax obligation that existed for appreciated assets.

Tax Details

"Tax basis" is the price of an asset for tax purposes. Usually, it's the purchase price; but with some assets the basis can also be adjusted over time (e.g. the basis of investment real estate gets adjusted via depreciation). When you sell an asset for a profit you owe capital gains tax on the gain; calculated as the difference between (1) the selling price and (2) your tax basis.

When an individual passes away, tax rules specify that the tax basis is adjusted to the asset's value at the date of the owner's death. Appreciated assets have their basis "stepped up"; and the reverse is also true (assets that have declined in value have their basis "stepped down"). For highly appreciated assets, this step-up in basis can significantly reduce the tax liability when the asset is eventually sold by the inheritor.

How the above step up/down in basis impacts married couples can get a bit more complex, and depends on a few circumstances:

Does the married couple live in a community property state? There are currently 9 states that have community property laws. The unique rules and laws of how community property rules work is complex, and far beyond the scope of this knowledge base. However, for the purposes of this tax strategy, its reasonable to think of the rules as assets held by a married couple in a community property state are "100% owned by each spouse".

In a community property state, the surviving spouse should get a 100% mark up in basis. Due to community property rules, each spouse owns 100% of all marital assets. As such, when one spouse dies, all assets (regardless if they are owned/held individually or jointly) should be stepped up/down in basis.

If the married couple lives in a separate property state, how were the assets held (individually, or joint)? Married couples can own investment accounts and assets jointly, or individually -- and this decision has a large impact on if/how the tax basis will be adjusted upon death.

In a separate property state, the surviving spouse may get a 0%; 50% or 100% mark up in basis. States with separate property rules acknowledge individual and joint ownership. Due to that, if/how much an asset would be marked up at death depends on how the assets are owned/held:

• Asset was owned by deceased spouse individually: 100% mark up in basis

• Asset was owned by deceased spouse jointly: 50% mark up in basis

• Asset was owned by surviving spouse individually: 0% mark up in basis

A Tax Planning Strategy Exists for Individuals Living in Separate Property States

If a married couple living in a separate property state has highly appreciated assets, and one of the individuals is expected to pass away prior to the other -> proactive financial planning could help the surviving spouse save/avoid a significant tax bill.

• As noted above, in a separate property state, depending on how the assets are owned, the tax basis could be marked up 0%, 50%, or 100% upon death (depending how assets are owned).

• Married couples generally have an unlimited amount that they can "gift" to one another.

• If one individual is anticipated to pass away prior to the other, strategically "gifting" all the highly appreciated assets to that individual would allow the surviving spouse to receive a 100% markup in basis.

Key Benefits

• Reduce/eliminate future capital gains taxes. By gifting/transferring assets that have appreciated significantly to the spouse anticipated to die first, the future capital gains tax that would be owed upon selling these assets can be eliminated for the surviving spouse (via the step-up in basis that occurs upon death).

Key Considerations/Flags

• Advance planning is required. To take full advantage of this strategy, the transfer of assets must be completed well before the spouse's death. Rushing this process can lead to errors and potential tax complications.

• Spouse receiving "gifted" assets must own them for at least 1 year. The IRS has a rule that says gifted assets must by held by the recipient at least one year for step-up in basis rules to apply.

• Loss of control of "gifted" assets. Gifting is a one-way door, and cannot be undone. The spouse who receives gifted assets needs to leave those assets to their spouse for this strategy to work as intended. But they have no obligation to do so.

Strategy: When to Consider This and When to Avoid It

🟢 When to Consider This Strategy:

• This strategy typically comes into play when a spouse receives a terminal diagnosis. By transferring the assets in advance, the surviving spouse can benefit from the step-up in basis upon the other's death, potentially eliminating a significant tax liability.

• If you're actively seeking ways to make your estate transfer more tax-efficient, this strategy could be an effective part of your plan. By eliminating the capital gains tax on appreciated assets, a potentially heavy tax burden can be avoided.

🔴 When to Not Use This Strategy:

• If there's no anticipation of an unexpected death, this strategy may not be beneficial. The timing of the asset transfer is crucial to utilizing the step-up in basis effectively.

• If your estate isn't burdened with significant capital gains taxes or if you don't own highly appreciated assets, other estate planning strategies might be more suitable.

• If you're not comfortable with the loss of control that would come with implementing this gifting strategy.

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