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Do assets within an irrevocable trust appreciate tax free?

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George23

Junior Member
What is the name of your state? California

I'm interested in creating an AB Trust for my family. The AB Trust section of Nolo's Make Your Own Living Trust says after the first dies, an irrevocable trust [Trust A] is created and "The trustee shall pay to or spend for the benefit of the surviving spouse the net income of Trust A at least quarterly."

Is there some reason for mandating the surviving spouse to take the income? From my understanding, assets within the irrevocable trust can appreciate tax-free. Unless the surviving spouse needs the money, why would he/she want to take it out and report it as income?

Thank you in advance for your time and advice.What is the name of your state?
 


abezon

Senior Member
Assets always appreciate tax-free. There is no income until the asset is sold, at which point the gain is taxable.

The point of an AB trust is to avoid probate fees & protect heirs (from something like the surviving spouse remarrying a gold digger). All community assets should be titled within the AB trust, & each spouse should have a separate AB trust for any separate assets. Thus, unless the surviving spouse has significant separate assets, she will need the quarterly income. When the first spouse dies, the trust assets get a step up in basis. Upon the second spouse's death, the assets of the trust receive another step up in basis, which is good.

If your estate is significant or you have special issues (blended family, kids who make bad financial decisions), it's better to have a professional estate planner draw up the trusts & will.
 

George23

Junior Member
"When the first spouse dies, the trust assets get a step up in basis. Upon the second spouse's death, the assets of the trust receive another step up in basis"

I was under the impression that each spouse's share gets one step up in basis tied to the value of their respective dates of deaths. When the surviving spouse dies, the value of the predeceased spouse's trust is unaffected by this event. No?

Thank you.
 

abezon

Senior Member
You live in a community property state. Only half of the value of the community assets is included in the estate of the first spouse to die, but the surviving spouse gets a full step up in basis. Generally, you set things up so that assets that are expected to keep going up in value get the second basis step up, while the surviving spouse uses the more static assets to cover living expenses.
 

George23

Junior Member
So as I understand what you are saying, when the first spouse dies, half of the estate (assets least likely to appreciate) goes into irrevocable Trust A but the entire estate's cost basis is set to the value on that date of death. When the second spouse dies, the other half and any new assets go into Trust B with a new step-up basis tied to the value on the second's DOD. Is this correct?

Thank you.
 

LdiJ

Senior Member
So as I understand what you are saying, when the first spouse dies, half of the estate (assets least likely to appreciate) goes into irrevocable Trust A but the entire estate's cost basis is set to the value on that date of death. When the second spouse dies, the other half and any new assets go into Trust B with a new step-up basis tied to the value on the second's DOD. Is this correct?

Thank you.
No, that is not what he is saying at all.

There is only one trust. Its simply that the surviving spouse takes distributions from the trust (for living expenses etc.) but takes those distributions from the assets that are least likely to appreciate, while leaving the assets more likely to appreciate alone. That way, when the next beneficiary inherits the trust, they get another stepped up basis, and the trust could be liquidated (if needed or desired) with little to no capital gain.

Example:

The assets of the trust contain a house which is appreciating, stocks which are climbing in value nicely, and some CDs with modest interest earnings.

If the surviving spouse needs to have some income from the trust for living expenses, the spouse liquidates the CDs rather than the house or stocks, because the CDs are growing the least. The house and stocks are left alone.
 

FlyingRon

Senior Member
CD's do not appreciate at all (in the conventional sense). The money you earn on them is INTEREST not capital gain.
 

LdiJ

Senior Member
CD's do not appreciate at all (in the conventional sense). The money you earn on them is INTEREST not capital gain.
I was simply copying his phraseology. I am well aware that CD's earn interest rather than gaining value.
 

George23

Junior Member
There is only one trust.
This trust [Trust A] is irrevocable and holds 1/2 of the estate's value, the first to die's share, on the date of his/her death.

Its simply that the surviving spouse takes distributions from the trust (for living expenses etc.) but takes those distributions from the assets that are least likely to appreciate, while leaving the assets more likely to appreciate alone.
The distributions are taxed on a capital gains step-up basis on the date of the first to die.

That way, when the next beneficiary inherits the trust, they get another stepped up basis, and the trust could be liquidated (if needed or desired) with little to no capital gain.
When the second spouse dies, doesn't Trust A's basis remain tied to the first spouse's DOD? After all, it was his/her share. I thought an irrevocable trust's basis remains fixed to the date when it was created. No?

Thank you.
 

tecate

Member
If this is a typical California A\B trust, I agree with you, George. On the second death, the assets in Trust A are not includable in the survivor's gross estate for estate tax purposes, and retain their cost bases relating back to purchase or the date the first died, whichever is later.

As for your question about drafting the A trust to provide for discretionary income and principal payments, it can be done, but it is dangerous (for estate tax purposes) to allow the surviving spouse to determine when any payouts can be made, even if under an ascertainable standard. Accordingly, these usually have a special trustee empowered to make the distributions. Also, there may be income tax reasons why the income should pass through. (The income earned by Trust A is taxable to the trust, at compressed rates, unless it passes through to the spouse, in which case it is taxed on top of his or her income.) However, in large estate situations, or if there is a compelling non-tax reason, where the surviving spouse is not expected to touch the A trust, drafting it this way may be worthwhile. Numbers need to be crunched and a crystal ball needs to be looked at carefully before doing this. I don't think this type of planning is for DIYers, so be careful.
 

George23

Junior Member
Referring back to my original question regarding the directive stipulated in Nolo's Make Your Own Living Trust: "The trustee shall pay to or spend for the benefit of the surviving spouse the net income of Trust A at least quarterly.", is there a reason or law that mandates that the income from the irrevocable trust be paid? If the trust's tax rate is less than the spouse's personal tax rate, shouldn't the trust's income remain within the trust? Did the author get it wrong? Shouldn't the wording be "may" rather than "shall"? And why quarterly?

Thank you again.

PS: I acknowledge I had it wrong and should written "assets most likely to appreciate go into Trust A while assets generating the most income are left out of Trust A".
 

tecate

Member
Referring back to my answer, take your choice on which way you and your spouse want it. The author didn't get it wrong, its just that most want the income payout provision. If you don't, then so be it. This is a planning issue, not a right vs. wrong issue.

These are forms, only, not stipulated directives. Forms can be changed to fit particular circumstances.
 

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