How to Defeat Capital Gains Tax

Conventional wisdom holds that a properly crafted and implemented estate plan serves to defeat two horrible outcomes: probate and conservatorship.

Probate is a certainty if something is not done to avoid it, since it is a process which occurs after one’s death. It is the formal process by which title is changed on assets left behind by a decedent – but it is truly a nightmarish process. It is a formal court proceeding which freezes all assets, takes at least 18 months (usually considerably longer), makes one’s personal affairs public, and is essentially a court-sanctioned forum for families to fight. And, it costs a ton of money.

Conservatorship is what “the system” has in store for unprepared people who don’t quite die, but rather become incapacitated. Whether a person is young or old, if they are rendered unable to manage their own affairs, if they have not prepared for this possibility they will be subjected to a superior court process in which a judge will determine who will be put in charge of the incapacitated person’s financial affairs, and who will be given authority to mange their medical care. And married folks – it’d be reasonable to assume that your spouse would automatically have such authority, right? Wrong. There is no “automatic” designation of a conservator – a spouse would likely have the “inside track,” but they would nonetheless need to endure the conservatorship process. Which, like probate, is heard in a public forum, takes a long time and… surprise – costs thousands of dollars to get started. And even worse than probate, it will continue indefinitely until the subject either regains their capacity or dies.

Thankfully, as noted above, a properly prepared estate plan will conclusively defeat these two horrible processes.

But wouldn’t it be nice if one’s estate plan could go beyond merely beating down bad outcomes and could, in fact, deliver an amazing tax outcome as a sort of “bonus?” Good News – as residents of California which happens to be one of nine so-called “Community Property” states, we are fortunate to be graced with the ability to completely eliminate capital gains tax on any asset that is held in one’s living trust – Twice, if you’re married!  That’s the good news…  the bad news is that the triggering event that delivers what is known as a “full step-up in cost basis” is a trustor’s death.

What that means on a practical level is that as soon as one completes the process of “funding” their trust, all assets that are then (properly) titled in the trust are then positioned to receive the “step-up” upon death. This is particularly compelling for married couples, since the first step-up occurs upon the death of the first spouse/trustor to die, meaning that the surviving spouse/trustor could then sell ANY asset of the trust, and pay NO capital gains tax.

This effect is achieved regardless of the nature of the asset (e.g. a primary residence, a rental property, a bar of gold, etc.), regardless of how much it has gone up in value since the date of its acquisition – not the date of its transfer into the trust, mind you, and regardless of how long you’ve owned it. (Single folks get this result as well, but only once.) Back to our married example, though – if the surviving spouse opted to not sell the asset following the death of their spouse, when the assets flow to the children (or any beneficiary) upon the death of the survivor, the children are entitled to a SECOND step-up, meaning that they could sell any highly appreciated asset and pay NO capital gains tax!

The way that this amazing “double step-up in cost basis” is obtained is by way of any ancillary document that can accompany one’s living trust – it has different names, but we at Botti & Morison call it a “Community Property Agreement.” Its purpose is to have all assets of the trust treated for tax purposes only, as if they had been titled as Community Property. This way, one can truly obtain the best of both worlds – when an asset is properly titled in one’s trust, it will be afforded the probate avoidance that the trust titling delivers, but when it is treated for tax purposes as if it had been titled as Community Property, it is eligible for the double step-up in basis that Community Property titling delivers.

Just when you were about to give up on California and move to Oregon (which happens to ironically NOT be a Community Property state), you may want to reconsider. Just kidding – if you establish your estate plan here, you may be able to take this amazing tax advantage with you wherever you decide to move. At this point, we’re on the verge of delivering nuanced tax advice, and, although tax planning is an integral component of well-rounded estate planning, we recommend you confer with your tax preparer to verify that you can take this tax benefit with you wherever you go – and anyway, have you seen Bend, Oregon lately? It’s turned into Orange County – you might as well stay here.

If you have any questions or would like more information, please don’t hesitate to call (877-585-1558), email us or register to one of our free webinars or workshops.

By Paul Morison