Estate and Tax Planning Post-OBBBA: The Shift from Estate Tax to Capital Gains Concerns

By Kelly McMahon O'Brien, J.D., LL.M. (Taxation)

The One Big Beautiful Bill Act has permanently changed the estate planning conversation, and not in the way most people expect. For the past two decades, estate tax avoidance has driven most planning decisions. That framework no longer fits the reality most families face.

The OBBBA permanently set the federal estate tax exemption at $15 million per individual and $30 million per married couple. For most middle-class and upper-middle-class families, federal estate tax exposure is no longer a primary planning concern. The estate tax problem, for this population, is largely resolved.

The Planning Problem Today: Capital Gains

The planning objective has shifted from reducing the taxable estate to identifying which assets should be held until death to reduce capital gains tax for the family. This is especially true in communities like the Flathead Valley, where real estate values have appreciated dramatically over the past several years.

IRC Section 1014, the step-up in income tax basis at death, is now the most consequential tax planning tool available to most middle-class and upper-middle-class clients. Here is what that means in plain terms. When you own an asset that has grown in value over the years, the difference between what you originally paid for it and what it is worth today is the portion that would be taxed if you sold it. When that same asset passes through your estate at death, the taxable value resets to whatever the asset is worth on the day you die. The appreciation that built up during your lifetime is no longer subject to tax. Your family inherits at full current value with no tax owed on years of growth. That benefit applies to assets that pass through your estate. It does not apply to assets you give away as gifts during your lifetime.

Example: How the Step-Up in Basis Works

You purchased a piece of land for $150,000 twenty years ago. It is worth $900,000 today. You have $750,000 of embedded capital gain.

If you sell during your lifetime, you pay capital gains tax on $750,000.

If you hold until death and the property passes through your estate, the basis resets to $900,000. Your heirs inherit at full current value. The $750,000 in gain is eliminated entirely.

Why Existing Plans May Now Work Against You

Many estate plans were designed for a very different tax environment, and the rules have changed significantly. One of the most common features in older plans is something called a formula clause. In plain terms, a formula clause instructs the plan to automatically fill a bypass trust with as much as can pass free of estate tax at the first spouse's death. When estate tax exemptions were low, that made sense. If the exemption was $1 million, the formula directed $1 million into the bypass trust and the rest stayed with the surviving spouse.

Here is where the problem starts today. The OBBBA set the exemption at $15 million per person. Most families do not have a $15 million estate. That means a formula clause written in 2010 will now direct the entire estate into the bypass trust at the first spouse's death, because the entire estate falls under the exemption amount.

Example: When a Bypass Trust Becomes a Liability

A couple has a $4 million estate, including a ranch that has grown significantly in value over the years. Their plan, written in 2010, includes a formula clause that directs as much as possible into a bypass trust at the first spouse's death to use up the available exemption. Because the exemption is $15 million and the entire $4 million estate falls well below that threshold, the formula clause sweeps the full estate into the bypass trust, including the ranch.

Under the old rules, this saved estate tax, but today there was never an estate tax problem to solve. The ranch is now locked inside the bypass trust with no way for the surviving spouse to benefit from what happens next. When the surviving spouse dies, assets held inside the bypass trust do not receive a step-up in basis. The family sells the ranch and pays capital gains tax on decades of appreciation. If the ranch had remained in the surviving spouse's estate and passed at their death instead, that tax would have been avoided entirely. The provision written to protect this family is now working against them.

What a Plan Review Should Address Now

If your estate plan has not been reviewed since the OBBBA was signed, that review is worth scheduling. The questions your adviser should be asking are no longer centered on the size of your taxable estate. They are centered on the embedded gain in your appreciated assets and whether your current plan protects or forfeits the most powerful tax benefit available to your family.

Areas worth examining include:

• Review bypass trust formula clauses. Under today's exemption, a formula clause may sweep your entire estate into the bypass trust rather than just a portion. In many cases the fix is updating the plan so the trust is optional rather than automatic, giving the surviving spouse the ability to decide at the time of death.

• Consider portability versus bypass trust. Portability allows a surviving spouse to carry over the deceased spouse's unused exemption rather than locking assets into a trust. It can accomplish the same goal without forfeiting a second step-up in basis, but it requires a timely election and does not happen automatically.

• Identify which appreciated assets should remain in the surviving spouse's estate to preserve the step-up in basis at the second death.

• Revisit lifetime gifting strategies involving appreciated property. Gifts transfer your original basis to the recipient rather than eliminating the gain.

• Review irrevocable trust holdings for step-up eligibility, as assets transferred to irrevocable trusts during life generally do not receive a step-up at death.

The OBBBA has not made estate planning less important. It has made it different. The families who benefit most from proactive planning today are not necessarily the wealthiest. They are the ones with the most appreciated assets and the plans designed for a world that no longer exists.

Ready to Review Your Plan? Schedule a consultation with Measure Law, PC to assess how the OBBBA affects your existing plan and what adjustments may be warranted.