The IRS has changed the rules regarding taxes on inheritances, curbing the tax break on a particular kind of trust often used to minimize estate taxes. According to the article “IRS quietly changes rule on how your children’s inheritance is taxed” from The Daily Mail, the agency has clarified how irrevocable trusts are taxed.
Before Revenue Ruling 2023-2, it was unclear what the tax policies were around assets passing to beneficiaries through an irrevocable trust. However, the ruling has confirmed that these trusts will now be subject to capital gains tax, significantly impacting estate planning.
Assets distributed during a person’s lifetime are typically subject to capital gains taxes on the increase in value of the asset over time. The tax is determined largely by the difference between how much the asset was worth when it was purchased and the value at the time it was transferred.
The exception to this rule has been when assets are passed to beneficiaries at the time of an individual’s death. The owner’s death gives the recipients a “step-up in basis,” so they inherit the asset as if it had been purchased at the current value rather than when it was purchased. This eliminates any capital gains taxes.
Before the new ruling, transfers from irrevocable trusts generally received this tax break. The ruling now states that any property held in an irrevocable trust not included in the taxable estate at death will no longer receive a step-up basis.
This new rule must be considered to avoid substantial costs to heirs.
Let’s say a couple purchased a home in 1975 for $100,000, and the home is now worth $250,000. If they want to sell the home, the couple will owe capital gains on the $150,000 increase in value. Before the ruling, if they transferred their home into an irrevocable trust, the trust could sell the home from a cost basis of $250,000, and there would be no capital gains due if the proceeds were distributed to their children.
The ruling doesn’t mean trusts are no longer useful. However, planning needs to be more careful, with the help of an experienced estate planning attorney.
It is now critical to be sure any trust included in the taxable estate at death uses correct wording, so the value of the assets is included in the taxable estate.
Most families will not yet find themselves subject to federal estate tax, even if the value of their home is included because the current federal estate tax exemption is only applicable to estates valued at $12.92 million or more. However, in 2026 the estate tax limit will be lowered to about half that amount.
Seek advice from an experienced accountant, financial planner and estate planning attorney to protect heirs from this important change from the IRS.
Reference: Daily Mail (July 5, 2023) “IRS quietly changes rule on how your children’s inheritance is taxed”