We recently helped a family with a planning situation in our practice that may serve as a good educational tool for other families. I’ve changed the details of this case, but the fundamentals provide the insight.
A long-time married couple had retired and purchased a second home in a warmer state, but retained their Indiana home and residency. The second home had become very important to the couple, as the kids and grandkids found it fun to visit, and they found the new house was bringing the family together for relaxation.
The family had invested wisely, and owned a number of stocks and funds that had been purchased over the past few decades. Some of the stocks were some of the best performing, high profile US companies and over time the stocks had appreciated considerably. The funds had also performed well after being held for nearly 20 years. The investments were not owned in retirement plans.
Because the couple was comfortable with the investments, and to avoid some very, very hefty capital gains taxes, the family considered the positions as permanent fixtures on their balance sheet, and so when it came time to buy the second home, instead of using the money in the investments, they financed the purchase with a conventional mortgage. Each spouse had a pension, and with their two Social Security payments and Required Minimum Distributions from their retirement plans, they had plenty of monthly cash flow to cover the new mortgage payment. The dividends from the stocks and funds were being reinvested.
After purchasing the second home, the couple felt it would be easier to eventually administer their estate with homes in two different states if they created a Joint Family Revocable Living Trust. The Living Trust would enable them to serve as joint trustees while they were alive, and then authorize their oldest daughter as the trustee, to conduct the business of the estate, after the death of the second parent. After the trust was created, the investments and homes were retitled (not sold) to the new Revocable Living Trust.
Sadly, one of the spouses developed an illness and passed away about two years after the second home was purchased. The spouse’s pension had a very reduced survivor benefit (25% of the original benefit) and because the second Social Security payment for the deceased spouse was also lost, the remaining spouse saw their monthly retirement income reduced by roughly $3,200, which now made the second home mortgage payment much harder to service.
After exploring some options such as increasing the income from retirement plans, taking dividends from the investments in cash rather than reinvesting, or selling one of the houses, it was ultimately decided that both homes could be maintained if the mortgage on the second home was paid off. The question became how to accomplish this goal while incurring the least amount of taxes possible. The mortgage balance was $200,000.
As a potential solution the client was educated about the tax treatment of the investments held in the living trust after one of the original trust grantors (the couple themselves) passed. Because the trust was set up as a joint revocable trust by both spouses, assets that were re-titled into the living trust would get what is termed a step-up in basis. This means that because both grantors/trustees retained incidents of ownership in the assets of the trust while they were still living, the remaining spouse was considered an inheritor of 50% of the trust’s investments.
Pursuant to the stepped-up basis rules for inherited assets, half of the investments in the Family Trust had now “reset” their basis to the value of the investments on the day the spouse had passed. So now, instead of paying taxes on the gains on the investments over the past few decades, the surviving spouse would pay capital gains tax only on the appreciation on the stocks after the date of passing for the deceased spouse a few months prior.
The result of which was instead of paying nearly $35,000 in capital gains taxes when selling investments to pay off the house, trades were engineered that resulted in only $600 in capital gains taxes. The stocks were sold near an all-time market high, and the second home was paid off for the family to continue to enjoy together.
At a time when the Federal Estate Tax applies to very few households, when making estate planning decisions its important to be mindful of these types of issues. After a decade of strong stock market returns a stepped-up basis is likely to be a powerful tax planning tool for many families. Of course, each person should seek the counsel of legal and tax advice, as we do not provide these services in our practice.
This is a hypothetical situation based on real life examples. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investments or strategies may be appropriate for you, consult your financial advisor prior to investing. Marc Ruiz is a wealth advisor and partner with Oak Partners and registered representative of LPL Financial. Contact Marc at marc.ruiz@oakpartners.com. Securities offered through LPL Financial, member FINRA/SIPC.
