Everybody has heard the old saying that nothing is certain in life except death and taxes. But not everyone knows how death and taxes are inextricably linked. 

The final days leading up to the death of a loved one are often emotionally fraught, and finances are usually not top of mind for clients. Yet, certain tax strategy is simply too valuable to overlook. At stressful and confusing times, an astute advisor can be worth their weight in gold, especially if they have discretionary authority to act.

Our firm, Segment Wealth, manages client money with a focus on creating “unrealized gain,” the untaxed profit derived from avoiding or deferring sales activity. These untaxed profits are especially important when an investor dies because, via the step-up in basis rule, the IRS forgives taxes on unrealized gains at any owner’s death. The step-up rule is possibly the most powerful part of the tax code for investors who pay attention (and who don’t allow their brokers or their own over-trading to squander it). This power is the reason President Biden wants to nix this part of the tax code. Given that tax-thirsty politicians have tried and failed at this before, I’m betting Mr. Biden will too.

TAKE YOUR LOSSES

Unfortunately, this step-up knife cuts both ways since the rule erases unrealized losses too. Therefore, it’s important in a joint account where one party might have failing health to consider selling all losing positions prior to death to avoid losing this deductibility. That’s just the first step in utilizing the step-up rule to maximum effect, and there’s more to doing it right. 

First, it’s important to know how realized losses are handled by the IRS. Losses realized by joint parties are held in reserve for future deductibility until used up, either against realized gains or against earned income (limited to $3,000 per year). However, in the year of death, the portion of realized losses that belongs to the decedent (normally half) can be used on the final tax return, but not in future years. The survivor keeps their half regardless, still making loss sales advisable in most situations. But salvaging the value of the deductibility of the decedent’s portion is possible if you know what you’re doing. Now it gets tricky. 

USE YOUR GAINS

To salvage those losses, the survivor should realize gains on increases after the step-up occurred in the same year as death. Depending on market conditions, this could allow the survivor to use up the decedent’s lapsing losses against fresh, after-basis-reset gains in the final year that they are allowed. And, the survivor can immediately repurchase the same positions since the 30-day wash sale rule does not apply to gains. This would assure the higher cost basis in future years of individual ownership of the survivor, reducing future taxable gains proportional to the would-be evaporating losses in the final calendar year of the last joint tax return. Since stepped-up property is also always considered long-term from the start, even selling a few months later to use the gain against losses cannot cause short-term gain problems.

Clearly, this strategy would work best when a decedent passed away early in the tax year, allowing the most time in that same tax year for gains beyond the step-up date to percolate. Even if minimal gains are earned in the remaining part of the year after the step-up, any value derived from the exercise would have gone to zero anyway if simply ignored, and the survivor keeps their half of the losses regardless, making this strategy routinely beneficial. Every taxpayer’s situation is unique. Be sure to ask your tax counsel about how this might apply to you.

This type of tax control proves that individual stocks can be more powerful than their ETF or mutual fund brethren since cherry-picking the biggest gainers and losers in narrow time windows can’t be done as efficiently with funds. This is the same phenomenon that makes individual stocks better currency for charitable giving as well.

I understand the emotional roller coaster that family members can experience in the final days or months leading up to the loss of a loved one. When emotions are high, the guidance of a trusted advisor becomes all the more valuable. Just make sure you keep them in the loop and don’t surprise them after the fact.

Please see IMPORTANT DISCLOSURE information.