A Living Trust Keeps the Step-Up in Basis. An Irrevocable Trust Built to Dodge Estate Tax May Not
A retired dentist spent years assuming a particular trust structure would shield his family from estate taxes, but the real bill waiting for his children had nothing to do with estate tax at all.
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In 2022, a 74-year-old retired dentist sat through an estate-planning seminar and came away convinced that the federal tax on his estate would take a large share of what he left his two children. Within months he moved $1.2 million of stock, bought decades earlier for $200,000, into an irrevocable trust for them. He also filed a gift tax return.
He died in 2026, and by then the shares were worth $1.6 million. His children sold them to split the money and diversify. They assumed the cost basis reset at death. Their CPA corrected them: the trust inherited his $200,000 basis along with the stock, which left a seven-figure taxable gain.
His whole estate, trust included, came to about $4.4 million. The basic exclusion amount for those dying in 2026 is $15,000,000. The trust saved his family nothing in estate tax, and it cost them the step-up.
Only Assets in the Taxable Estate Get a Fresh Basis
Under 26 U.S.C. § 1014(a)(1), property acquired from a deceased takes a basis equal to its value on the date of death. Section 1014(b) lists what counts. Paragraph (b)(2) covers property put in a trust where the decedent kept “the right reserved to the decedent at all times before his death to revoke the trust.” That describes a standard revocable living trust. The owner keeps control, the assets stay in the gross estate, and the heirs get the step-up.
An irrevocable trust funded with a completed gift works under a different rule. Under 26 U.S.C. § 1015(a), the person who receives a gift takes the same basis the donor had. In Rev. Rul. 2023-2, the IRS said that an irrevocable grantor trust whose assets stay out of the gross estate “does not fall within any of the seven types of property listed in Section 1014(b).” The assets get no step-up, even though the grantor paid the trust’s income tax while he was alive.
Carryover Basis Costs This Family $333,200
On a sale at the death valuation, the children’s gain is $1,400,000. This example assumes federal tax only, at the top long-term capital gains rate of 20% plus the 3.8% net investment income tax, for a combined 23.8%. State income tax would raise the bill.
- Sale price: $1.6 million
- Carryover basis: $200,000
- Taxable gain: $1,400,000
- Federal tax: $333,200, or $166,600 per child
If the same shares had been in a revocable living trust, their basis would have reset to $1.6 million. A sale at that price creates no gain, so the federal tax is zero.
A Living Trust Would Have Avoided Probate Without Losing the Step-Up
A revocable living trust handles the job most families actually need done. It keeps assets out of probate, names a successor trustee, and holds onto the step-up under § 1014(b)(2).
The irrevocable trust can lose even for estates large enough to owe tax. The amount he gave counted against his lifetime exemption, so the trust kept only the growth after the gift out of his estate. At the top estate tax rate of 40%, protecting $400,000 of growth saves $160,000. The lost step-up costs $333,200. For assets with a very low basis, the income tax cost was larger than the estate tax savings.
Some grantor trusts include a power to swap assets. Planners often use this kind of provision, such as a Sec. 675(4) power. It lets the grantor take low-basis stock back out of the trust and put in an equal amount of cash. The stock returns to his estate and gets its step-up at death. Using that power late in life fixes most of the problem.
Five Moves That Protect the Step-Up
- Start with the trust instrument. Find the clause that says whether the trust is revocable. If it is irrevocable, look for a power to substitute assets of equal value.
- Compare the estate to the exemption. Add up the whole estate and measure it against the $15,000,000 federal exclusion and against your state’s estate tax threshold. If you are well under both, an irrevocable trust set up to avoid estate tax is solving a problem you don’t have.
- Build a basis schedule. For every asset in an irrevocable trust, list the original cost and the current value. The assets with the biggest gap are the first ones to swap back.
- Line up executor paperwork. If a Form 706 is filed, heirs may receive a Schedule A (Form 8971) and must use the value it reports as their basis. Get date-of-death appraisals for anything that steps up.
- Skip deathbed gave to a parent. Under § 1014(e), appreciated property you give to someone within 1 year of their death comes back to you with the original basis.
A CPA or estate tax attorney can show how the swap power and your state’s rules apply to your own trust. The wider checklist, beneficiary forms, titling, and the paperwork that decides whether money passes to family or to lawyers, we put in a free estate guide here.
One Number Settles the Choice
For a family well under the exemption, the irrevocable trust saved $0 in estate tax and cost $333,200 in capital gains tax. Before signing anything irrevocable, compare the estate tax it saves with the basis it gives up.
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Vilma Rios is a tax professional and tax content contributor with more than 15 years of experience in tax and accounting. She specializes in federal tax research, tax education, and translating complex tax rules into clear, practical information for individuals, families, and small-business owners.
Vilma is a Content Tax Contributor II with the National Association of Tax Professionals (NATP), where she contributes to tax education and professional content. She has also presented tax information through webinars, including Spanish-language tax education, and has appeared on Telemundo 47 discussing tax topics and helping viewers understand important tax-filing requirements.
Her experience also includes tax and accounting work, tax research, IRS-related matters, and public tax education. While in college, Vilma volunteered in an IRS-sponsored tax assistance program and was recognized for her community service by local and state officials.
Known as “Your Tax Geek,” Vilma is passionate about making taxes easier to understand and helping people navigate an increasingly complex tax system.
