You Can Have the Exclusion or the Step-Up. You Rarely Get Both.

Every estate plan eventually runs into the same fork in the road: move an asset out of your estate and protect it from estate tax, or leave it in and let your heirs inherit it at a stepped-up basis. You can rarely do both. With the exclusion now at $15 million per person, $30 million per couple, most families have quietly stopped thinking about this trade-off , which is exactly when it gets missed. 

The Question

The most commonly known cost of moving an asset outside of your estate is the reduction of your lifetime exclusion. With that exemption at $15 million, it’s not quite as precious as it once was. But there’s another cost: your cost basis (no pun intended). 

Property included in your estate at death gets a step-up in basis. All the appreciation of an asset (the difference between what you paid for an asset and what its worth) disappears. Your heirs could sell it the day after your funeral tax free. The same isn’t true of property successfully removed from your estate. Your heirs take your original basis and inherit the embedded gain along with the asset.

You can’t have it both ways. So is it the basis eraser or the estate tax exclusion? As with everything you ask your advisor, it depends. Let’s take a look at the layers. 

Layer One: The Federal Estate Question

The federal layer is actually the easiest question to answer. What is your marginal estate tax rate? With the personal exclusion sitting at $15 million, that rate is 0% for most of us. If you find yourself under that exclusion amount, moving assets outside of your estate isn’t saving you anything at the federal level, and you’re giving up a step-up in basis. 

It’s a different story for those above the exclusion. A 40% marginal rate beats any capital gains rate at any basis (yes, even you Californians and New Yorkers). This doesn’t mean you move assets out indiscriminately. As a general rule, you would want to target appreciating assets with a high basis ones when you have a choice. The further you climb above that federal exclusion threshold, the less that basis matters.

Layer Two: Your State

Twelve states and the District of Columbia impose their own estate tax, with thresholds far below the federal figure and, in most cases, no portability (including Washington, California, and New York). That last part is crucial. The first spouse's state exclusion evaporates if it isn’t used at their death, so there’s no “wait and see” option. 

Don’t forget about your state’s income tax. Forfeiting a step-up costs far more where gains are taxed as ordinary income than where there is no income tax. Some states tax your estate and never touch the gain. Others do the reverse. Some do both. 

Layer Three: Community Property or Common Law

Here is the layer that gets skipped, and it can outweigh the other two.

In a community property state, community assets receive a full basis step-up at the first death. Both halves. Appreciation is wiped clean at the first spouses death and again at the second spouses death. In a common law state, jointly held property steps up only on the decedent's half, and the survivor carries their original basis on the rest until their passing. This can matter very little or very much depending on a number of factors, especially when there’s a large gap in the age of spouses. 

It also means how you title property while both spouses are living can make . Several common law states now permit elective community property trusts for this reason. That conversation has a deadline, and the deadline is a funeral.

What Tips the Scale

Toward removing: basis close to market value, assets you expect to appreciate sharply, transfer tax exposure at any level, heirs who intend to hold, and every non-tax reason trusts exist. Creditor protection and remarriage concerns don’t care about basis.

Toward keeping it includible: deeply appreciated or zero-basis property, no transfer tax exposure anywhere, heirs who will sell soon after death, depreciated real estate carrying recapture, and a state that taxes gains heavily. 

And don’t forget about timing. A gift with decades of runway is a completely different transaction than one made near the end of life.

The Verdict

Work the layers in order. Federal, then your state, then how your state treats marital property. You’d be surprised how many people come to a different conclusion than what existed before this exercise. 

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