A family in Brooklyn comes to my office. Their parents bought a brownstone in the 1980s for around $80,000. Today, it’s worth over $3 million. The children, now adults, know they will inherit this property and are rightly concerned about the tax bill. They’ve heard that a living trust is the answer to avoiding a massive capital gains tax when they eventually sell.
This is one of the most common reasons clients seek me out, and it’s based on a partial truth. A trust is an essential tool for stewardship, but it isn’t a magic wand for taxes. The real value is not in avoiding the tax, but in positioning the asset for the next generation. The mechanism for this is the “step-up in basis.”
The Truth About Revocable Trusts and Taxes
Let’s first clear up the popular myth. A standard revocable living trust—the kind most people use for estate planning—does not, by itself, eliminate capital gains tax during your lifetime. For income tax purposes, the IRS treats a revocable trust as a “grantor trust.” This means it’s transparent. It’s still you.
If you place that Brooklyn brownstone into your revocable trust and decide to sell it a year later, the capital gains are calculated based on your original purchase price (your “basis”) and are reported on your personal income tax return. The trust, in this scenario, changes nothing about the immediate tax consequence of a sale.
Where the trust becomes powerful is upon your death. It works with a crucial provision in the tax code to protect your beneficiaries from the tax on a lifetime of appreciation.
The Real Advantage: Step-Up in Basis at Death
The true tax benefit for your heirs comes from a concept called the “step-up in basis.” When you pass away, federal tax law—specifically Internal Revenue Code § 1014—allows the cost basis of most inherited assets to be adjusted, or “stepped up,” to their fair market value on the date of your death.
Let’s return to our example. The parents’ original basis in the brownstone was $80,000. When the last parent passes away, the property is worth $3 million. At that moment, the basis for the children is no longer $80,000. It is stepped up to $3 million. If they turn around and sell the property for $3.1 million, they only owe capital gains tax on the $100,000 of appreciation that occurred after they inherited it. The millions in gains accrued during their parents’ lives are effectively forgiven for tax purposes.
This step-up happens for assets passed through a will as well. So, why use a trust? Because a properly funded trust bypasses Surrogate’s Court. The transfer of ownership is private and efficient, avoiding the time and expense of probate in New York. The trust acts as the vehicle to deliver the asset to the beneficiary, who then receives the benefit of the stepped-up basis. Stewardship.
Why the Type of Trust Matters
The planning I’ve described applies to revocable living trusts. An irrevocable trust is a different legal and tax instrument entirely. When you transfer assets to an irrevocable trust, you typically relinquish control and ownership. This can be a deliberate strategy for asset protection or reducing the size of your taxable estate, but it can have very different—and sometimes unfavorable—capital gains consequences.
In many cases, gifting a highly appreciated asset to an irrevocable trust results in a “carryover basis.” This means the beneficiary inherits your original low-cost basis, nullifying the step-up benefit and creating a significant future tax liability. The decision to use an irrevocable trust must be intentional and made with a full understanding of the trade-offs.
As trustee, the person or institution you name has a fiduciary duty to manage these assets prudently. Their powers are outlined in the trust document and governed by state law, such as New York’s Estates, Powers and Trusts Law (EPTL) § 11-1.1. This includes the power to sell property, but also the duty to act in the best interests of the beneficiaries—which certainly involves considering the tax impact of their decisions.
A well-drafted estate plan addresses these contingencies. It ensures the right assets are in the right kind of trust and that your legacy is transferred with generational care, not a surprise tax bill.
The first step in this process is to understand what you own and what it’s worth. I advise clients to begin by creating a simple inventory of their major assets and, if possible, their original purchase price or basis. With that information, we can hold a legacy review to map out a structure that serves your family’s future.
