The Step-Up Basis, the QTIP Election, and the Portability Decision
Walter dies in 2026. His estate includes a residence (FMV $1,400,000, basis $300,000), a brokerage account (FMV $2,200,000, basis $500,000), and an IRA ($1,000,000) naming his wife Helen as beneficiary. Walter and Helen live in California and hold the residence and brokerage account as community property. Walter's will leaves everything to Helen outright, but his estate planner had drafted a trust with a QTIP election option that was never funded. The estate's executor is considering a portability election and whether to allocate the residence and brokerage to a bypass trust instead. Helen is 68 and in good health; the couple's combined estate is $4,600,000.
1. Compute the income tax basis of the residence and brokerage account in Helen's hands after Walter's death, and explain the community property rule.
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Because the residence and brokerage account are community property, Helen receives a full step-up in basis on the entire asset, not just Walter's half. California is a community property state, and IRC § 1014(b)(6) provides that the entire community property interest is treated as passing from the decedent for basis purposes. This is the key advantage of community property over separate property.
- Residence: FMV $1,400,000; Helen's new basis is $1,400,000 (full step-up).
- Brokerage account: FMV $2,200,000; Helen's new basis is $2,200,000 (full step-up).
- IRA: Passes by beneficiary designation to Helen; no step-up for income in respect of a decedent. Helen's basis is $0, and distributions are ordinary income. (She may roll it into her own IRA.)
If the assets had been separate property, only Walter's half would step up: residence basis would be $300,000 + $700,000 = $1,000,000; brokerage basis $500,000 + $1,100,000 = $1,600,000. The community property characterization is worth $1,100,000 in additional basis here. The exam point: characterization drives basis.
2. Should the executor make the portability election? Analyze the trade-offs given the estate size and the unfunded QTIP trust.
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Portability analysis: The estate is $4,600,000, well below the federal exclusion amount (which is high enough that no estate tax is due). Portability allows Helen to use Walter's unused exclusion (DSUE). The election requires filing a timely Form 706 even though no tax is due.
Arguments for electing:
- Low cost (one return) and preserves Walter's exclusion for Helen's later estate.
- If Helen's estate grows (appreciation, inheritance, remarriage), the DSUE could save substantial tax.
- No downside if the estate is simple and no GST issues arise.
Arguments against / cautions:
- Portability does not preserve GST exemption - that is lost if not used.
- The DSUE is not indexed for inflation, so its real value erodes.
- If Helen remarries and the new spouse's estate is large, the DSUE may be wasted or unavailable depending on ordering rules.
- Filing costs and complexity.
The QTIP issue: The unfunded QTIP trust is a non-issue for the current plan - there is no trust to elect QTIP treatment for. If Walter had funded a QTIP trust, the executor could elect QTIP to defer estate tax and obtain a second step-up at Helen's death, but that requires the trust to exist and qualify. Recommendation: Make the portability election (cheap insurance) and consider funding a bypass/QTIP trust in Helen's own plan to capture a second step-up and control disposition.
3. Helen asks whether she should instead have received the residence and brokerage in a bypass trust. Evaluate the trade-offs.
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A bypass (credit shelter) trust would have kept the assets out of Helen's estate, but at a cost:
Advantages of the bypass trust:
- Estate tax exclusion: Assets in the bypass trust are not included in Helen's estate, protecting appreciation from estate tax at her death.
- Creditor and remarriage protection: The trust can shield assets from Helen's creditors and a future spouse.
- Control: Walter can direct remainder to his children.
Disadvantages here:
- Loss of step-up: Assets in the bypass trust do not get a second step-up at Helen's death (they are not included in her estate). Helen's basis remains the date-of-death basis. Given the community property full step-up she already received, putting the assets in a bypass trust would forfeit future step-up on appreciation.
- Complexity and cost: Trust administration, separate returns, and accounting.
- No estate tax need: With a $4,600,000 estate, the bypass trust solves a problem the couple does not have.
Better approach: Because the estate is below the exclusion, outright transfer plus portability is likely optimal - Helen gets the full step-up and flexibility. A bypass trust becomes attractive only if the estate is expected to grow substantially or if creditor/remarriage protection is a priority. The exam point: do not use estate tax tools when there is no estate tax problem; the step-up is often worth more than exclusion.