The QTIP became a popular estate planning tool in the early 1980s. But one question remains: does a QTIP trust get a step up in basis?
The concept of basis is one of the most critical concepts in estate planning. Basis is essential in determining the gain or loss when an asset is ultimately sold. Accordingly, you want your basis as high as possible, and you should always look for a way to get a step up in basis.
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Background
So let’s answer the important question upfront. Does a QTIP get a step up in basis?
Yes. In most situations, the QTIP trust assets get a basis step up when the first spouse dies and a second basis step up upon the death of the second spouse.
Just as critical, the QTIP assets receive a full step-up in basis when the surviving spouse passes away because the assets are included in the gross estate of the surviving spouse.
To elaborate, a QTIP trust typically qualifies for the marital deduction. The result is no estate tax (at the federal level) upon the death of the first spouse. As such, the assets get a step-up in basis. When the surviving spouse dies, the QTIP assets are included in their estate. As a result, assets will get a second basis step-up.
There are various ways to obtain trust benefits for a surviving spouse while gaining the chance to get a second basis step-up at the surviving spouse’s death. One way is to have the assets from the first spouse pass to a particular type of trust that will qualify for the marital deduction. This will then be included in the surviving spouse’s estate for estate tax purposes at their death.
In short, the grantor transfers property to a trust for a designated term of years, during which time he is entitled to the trust income (interest & dividends) or the use of the property in the case of non-financial assets.
When the trust term ends, all the property in the trust is distributed to the designated “remaindermen” — usually the grantor’s children or a continuing trust for their benefit. If the grantor passes away during the trust term, the trust property reverts to his estate.
What is “Basis” and how does it work?
The concept of “basis” is critical in estate planning. When an asset is sold or disposed of, the seller uses a basis to determine if the seller incurs a gain or loss for income tax purposes. Capital gains tax occurs when the asset is sold for more than its basis. Conversely, a loss is recorded when the asset is sold for less than basis. Minimizing capital gains tax is a critical estate planning goal.
Irrevocable trusts used to be set up upon the death of the first spouse. This trust would use the deceased spouse’s assets to establish a Bypass (“Credit Shelter”) Trust that would generally qualify as a Marital Trust.
Proper Structure
Suppose the irrevocable trust satisfies the requirements to be a Marital Trust. In that case, a special so-called QTIP election can be made that will permit the trust assets to be fully included in the surviving spouse’s estate for estate tax purposes and then get a new (and expectedly higher) basis death of the surviving spouse.
As a result, many estate attorneys now draft irrevocable trusts established at the first spouse’s death to meet the Marital Trust requirements. As such, the surviving spouse can make the QTIP election. This election that the surviving spouse’s estate is not expected to be so big as to get hit with an estate tax that would exceed any income tax benefits.
A QTIP addresses these issues very well. A QTIP is a unique type of marital trust that allows the surviving spouse to be paid the net income of the QTIP annually. Other than the surviving spouse, no other beneficiary is allocated income during the spouse’s lifetime.
Does a QTIP Trust Get a Step up in Basis?
In general, the trust will qualify for the unlimited marital deduction, resulting in no federal estate tax when the first spouse passes away. The assets that are paid to the QTIP will get a step-up in basis.
When the surviving spouse later passes away, the entire QTIP will be included in their taxable estate. This means the assets in the QTIP will get a second step-up at that time. Not such a bad deal.
The appreciation in the QTIP assets over the surviving spouse’s life will get a new cost basis and then can be sold or disposed of without any capital gains. The result is that no income tax on the estate assets and no federal estate tax is due if the value of the combined QTIP assets and the surviving spouse’s assets are less than the portable exemption from the first spouse and the exemption of the surviving spouse.
How to Review QTIP Assets for Basis Step Up
If you are looking for a basis step up just follow these 5 steps:
- Separate QTIP assets from other estate assets
Remember that QTIPs are typically set up to allow one person to receive the trust asset income and then the assets pass to the final beneficiary. These assets need to be separately identified for tax purposes.
- Adjust assets to fair market value upon descendent death
When the first spouse passes away the assets will receive the initial step up. Disregard prior depreciation and record new depreciation in the QTIP tax return.
- Identity asset income stream
Income from the assets is now allocated to the recipient identified in the trust document. This person will receive a Form K-1 from the trust that will allocate taxable income.
- CPA or tax professional will record new depreciation
Don’t try to do the depreciation calculations yourself. Your CPA should record the new depreciation based on the new asset values.
- Make adjustment upon the death of the surviving spouse
Once the surviving spouse passes away, you must perform the same review noted previously. The good news is that no QTIP trust is required as the assets will pass to the remaining beneficiary.
Takeaway
As you can see, reviewing basis for QTIP trusts can be complex. Fortunately, most CPAs can help with the process and also file QTIP tax returns (Form 1041).
In the right situation, these trust can work great. This is especially the case with second marriages. Make sure you review your estate situation with a qualified attorney or CPA to determine if a QTIP is right for you!
