Every week, we meet with advisors who have a client who is choosing to pay two and a half million in taxes that could be permanently and legally avoided.

Before you say that none of your clients would ever make such a choice, you might want to see why we raise the issue. The estate tax exemption is currently $13.6 million per person for 2024, and is scheduled to be lowered at the end of 2025. The status quo is that by the beginning of 2026, each individual will only have about $7 million of exemption (indexed for inflation). Unless Congress passes new legislation and the president (whoever it is) signs it, that is the law.

No one ever says “yes, sign me up to pay an unnecessary $2.6 million[1] in taxes.” Not in so many words. But by their actions, or more precisely their inactions, that is exactly what many high net worth clients are doing.

The “Basis Step-up Trap”

We recently worked with and advisor whose client, Thomas, owned an apartment building worth about $14 million. His tax basis was close to zero. Thomas and his children were trying to decide how to get Thomas’s wealth to the children without paying more taxes than necessary.

One idea was that Thomas should hold the building until his death, so that the children could receive a step-up in basis, and avoid capital gains tax upon the sale of the asset.

But that approach would keep the $14 million building (and it might grow in value) in Thomas’ estate. What about estate taxes?

To make the “hold for a step-up” plan work to avoid both income and estate tax, Thomas has to die before the end of 2025, and the building value has to fail to keep up with inflation. If Thomas doesn’t die by then, or if his building increases in value more than inflation, unless Congress changes the law, his estate will likely end up substituting an estate tax for the avoided capital gains tax.

Not surprisingly, Thomas didn’t love the idea of his dying in the next two years. Fortunately, neither did anyone else.

And yet, by failing to get assets out of their estates, many wealthy people are in effect betting that either they’ll die within two years, or they’ll waste about $6 million of estate tax exemption.

Solution – Avoid Capital Gains Tax AND Estate Tax

Thomas owns real estate was worth $14 million, with no debt, and almost no basis. There is a simple, easy-to-implement solution that will allow Thomas to avoid estate tax on the value of the building, and avoid capital gains tax on the sale, without requiring Thomas to die.

The solution is to contribute the building to a Real Estate Shelter Trust. The trust would provide income to Thomas, and then his children, and then his grandchildren, for life.

Once Thomas contributes the building to the Real Estate Shelter Trust, Thomas no longer owns the building in his estate. Instead, he owns the lead interest (also called income interest) in the trust.

The building is still in the trust, and still worth $14,000,000.

But now, for tax purposes, only $12,600,000 is in Thomas’ estate.

That $12,600,000 is less than Thomas’ lifetime exemption of $13,600,000. So Thomas can give the lead interest (i.e. the right to receive income for several lifetimes) to his children, tax free.

So far, Thomas has avoided the estate tax.

Avoid the Capital Gains Tax

Now the building is out of Thomas’ estate, because it is in the Real Estate Shelter Trust, and Thomas has given his interest in the trust to his children.

The Real Estate Shelter Trust can then sell the apartment building, and because the trust is income-tax exempt, there will be no income tax on the sale of the building.

Thus, the entire $14,000,000 will be available to be invested, produce income, and grow for Thomas’ children and eventually his grandchildren.

Is it Really This Simple?

The short answer is yes. While of course there are details to be discovered about every client situation, and taken into account, the “dilemma” of having to choose between paying estate tax and paying capital gain tax can, in most cases, be completely avoided. If you have clients who are planning to hold assets because they want to get a stepped-up basis, and who will have taxable estates if the exemption comes down, Sterling could be helpful with estate-planning. Please call us to discuss. Click here for our guide on selling appreciated real estate, or call 703 437 9720 and ask to speak with Connor. You can also email [email protected].

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[1] The $2.4 million is calculated as follows. A drop in the lifetime exemption from $13.6 million this year, to an estimated $7 million in 2026 is a drop of $6.6 million. At the federal estate tax rate of 40%, the estate tax on the lost $6.6 million of exemption would be about $2.64 million.