Estate Planning Essentials: Step-Up in Basis for Revocable and Irrevocable Trusts With Uncertainty

By: Randall A. Denha, J.D., LL.M.

Effectively structuring an estate plan requires a clear understanding of how assets are treated upon death, particularly regarding the step-up in basis. This tax principle adjusts the value of inherited assets to their fair market value at the grantor’s death, impacting capital gains tax obligations for beneficiaries. Whether assets held in a trust receive this adjustment depends on the trust’s structure and the grantor’s retained interests. Proper planning ensures tax efficiency and compliance with applicable laws.

Eligibility for Step-Up in Basis

The eligibility of trust assets for a step-up in basis is governed by Internal Revenue Code (IRC) Section 1014(a) and related Treasury Regulations, which generally provides that property acquired from a decedent is valued at its fair market value at the date of death. The key factor in determining eligibility is whether the assets are included in the decedent’s taxable estate.

Revocable Trusts: Assets in a revocable trust, where the grantor retains full control and can amend or revoke the trust, are typically included in the taxable estate. As a result, they qualify for a step-up in basis upon the grantor’s death, reducing capital gains tax liability for beneficiaries.
Irrevocable Trusts: Assets in an irrevocable trust, where the grantor relinquishes control, generally do not qualify for a step-up in basis unless certain conditions apply. If the grantor retains interests such as the right to income or control over beneficiaries, the assets may be included in the taxable estate under IRC Sections 2036 and 2038, allowing for a step-up in basis.

Types of Trusts and Their Tax Implications

The type of trust used in estate planning significantly affects whether assets receive a step-up in basis.

Revocable Trusts Revocable or living trusts are common estate planning tools that allow the grantor to maintain control over assets during their lifetime. Since these assets remain part of the grantor’s taxable estate, they benefit from a step-up in basis at death. For example, if a grantor purchased real estate for $200,000 and its value appreciates to $500,000 by the time of death, beneficiaries inherit it with a $500,000 basis, eliminating any capital gains tax liability on the $300,000 of appreciation that occurred during the decedent’s lifetime.
Irrevocable Trusts Standard irrevocable trusts do not automatically qualify for a step-up in basis because the grantor surrenders ownership. However, if structured to include retained powers or interests that result in estate inclusion under IRC Sections 2036 or 2038, assets may receive a step-up in basis. Without these conditions, beneficiaries may face higher capital gains taxes when selling inherited assets.
Grantor Trusts A subset of irrevocable trusts, grantor trusts are taxed as if the grantor owns the assets for income tax purposes under IRC Sections 671-679. If trust assets remain part of the grantor’s taxable estate at death, they can receive a step-up in basis. Estate planning attorneys must carefully structure these trusts to balance tax benefits and estate planning objectives.

Valuation and Documentation for Step-Up in Basis

Accurately determining the fair market value of assets at the time of death is essential for applying the step-up in basis. Different asset classes require specific valuation approaches:

Real Estate: Professional appraisals consider comparable sales and market trends.
Marketable Securities: Valued at the mean between the highest and lowest quoted selling prices on the date of death, as required by Treasury Regulations.
Closely Held Businesses and Illiquid Assets: Require expert valuation reports.

Proper documentation, including professional appraisals and valuation reports, ensures IRS compliance and helps minimize audit risks. Executors and trustees should work with tax professionals to support reported valuations.

Reporting Adjusted Basis for Tax Purposes

Estate administrators must accurately report the step-up in basis to ensure compliance with tax laws. Required filings include:

Form 706 (Estate Tax Return): Filed for estates exceeding the federal exemption threshold ($13.99 million in 2025, subject to annual inflation adjustments), this form details the assets included in the decedent’s estate and their fair market value.
Form 8971 (Beneficiary Reporting): Used to inform beneficiaries of their inherited property’s adjusted basis, clarifying future tax obligations upon sale.

Failure to properly report basis adjustments can result in IRS penalties, including accuracy-related penalties under IRC Section 6662 of up to 20% of the underpayment of tax and potential criminal penalties for willful misreporting. Estate executors and trustees should work with professionals to ensure accurate filings.

Understanding the step-up in basis and its application to trusts is essential for effective estate planning. While revocable trusts generally qualify, irrevocable trusts require careful structuring to achieve the same benefit. Accurate valuation and diligent tax reporting are critical to maximizing tax efficiency and ensuring compliance.

Potential Repeal of the Estate Tax and the Importance of Flexibility in Drafting

At the time of this writing, lawmakers are actively considering the possible repeal or curtailment of the federal estate tax, while retaining the federal gift tax. Although no changes have yet become law, such proposals have been discussed in recent years and could significantly impact estate planning strategies going forward.

The repeal of the estate tax, if enacted, would shift the emphasis of estate planning away from transfer tax minimization and toward income tax planning, particularly in regard to the step-up in basis. Simultaneously, the continued enforcement of the gift tax would preserve the need for compliance and careful planning around lifetime transfers.

Given this legislative uncertainty, flexibility in drafting estate planning documents is critical. Planners should consider:

Incorporating conditional provisions to adjust to future changes in the tax code.
Using grantor trusts with retained interests that allow for potential estate inclusion (and step-up in basis) without triggering immediate gift tax consequences.
Including trust toggles, disclaimers, and powers of appointment that permit modification of trust structure or tax treatment based on the law at the time of death or transfer.
Structuring plans that preserve optionality, allowing for estate inclusion where beneficial, or for gifting strategies if the step-up in basis becomes unavailable or irrelevant.

Attorneys and advisors should monitor legislative developments closely and be prepared to update plans accordingly. As tax policy continues to evolve, well-drafted, adaptable estate plans will be essential in achieving both compliance and optimal tax results.