What happens to bypass trust basis when the surviving spouse dies?

Key takeaway

Bypass trust assets generally receive no second basis adjustment when the surviving spouse dies if they remain outside that spouse’s gross estate, so their existing adjusted basis generally continues.

The rule turns on the property at the second death

For bypass trust property, inclusion in the surviving spouse’s gross estate is the test for another basis adjustment. Property in a qualified terminable interest property trust that is included under the QTIP inclusion rule is treated as acquired from the survivor.

Without an alternate valuation election, property qualifying as acquired from a decedent under section 1014 generally takes a basis equal to its fair market value at death.

The exceptions for income in respect of a decedent and certain gifts returned to the donor are explained below.

Continuing basis can change over time

The continuing basis is adjusted basis, rather than necessarily the value assigned when the trust was funded. Before calculating gain, loss or allowable depreciation, depletion or amortization, required basis adjustments apply.

Items properly added to a capital account, including qualifying improvements, increase basis. Depreciation and similar adjustments generally reduce it, and the depreciation adjustment cannot be less than the allowable amount.

On a sale or other disposition, gain is the amount realized above adjusted basis for determining gain. Appreciation alone is not that sale or disposition, and recognition remains subject to exceptions elsewhere in the income tax provisions.

Outright ownership changes the estate inclusion question

If property is distributed outright from the bypass trust and the survivor still owns it at death, its value enters the survivor’s gross estate to the extent of that ownership interest.

Property previously spent or otherwise no longer owned cannot be assumed included under that ownership rule. The basis rules and their exceptions still apply separately.

Estate inclusion alone does not establish that federal estate tax is payable. For a United States citizen or resident, the computation considers the taxable estate and adjusted taxable gifts, followed by the applicable credit.

Adjusted tax basis is the basis of property after the required increases and decreases, used to calculate gain, loss or allowable depreciation, depletion or amortization.

Income in respect of a decedent is income earned but not received by the decedent and not properly includible on the final return. It receives no new basis and is generally included in the recipient’s income when received.

Resources for your next conversation

Income tax, basis and trust taxation. Open this guide to put the second death question alongside the broader basis and trust income topics you want to discuss with your advisers.
Basis and trust tax records and questions checklist. Use this checklist to organize the trust’s basis history and the questions raised by earlier funding and later adjustments.
Asset and authority map template. Map which assets remain in the bypass trust and which the survivor owns outright before discussing the second death.

Frequently asked questions

Does electing portability create another basis adjustment?

No. Portability concerns the deceased spouse’s unused estate tax exclusion and does not itself provide a second basis adjustment. The property’s treatment at the survivor’s death must be considered separately.

Does distributing property from the trust reset its basis?

A distribution of property other than cash generally gives the beneficiary the trust’s adjusted basis, adjusted for any gain or loss the trust recognizes on that distribution.

A section 643(e)(3) election instead makes the trust recognize gain or loss as if it sold the property at fair market value. The election covers all distributions subject to it for that taxable year and is made on that year’s return.

What if appreciated property was gifted to the survivor shortly before death?

If appreciated property was given to the survivor within one year before death and passes back to the donor or the donor’s spouse, the recipient keeps the survivor’s adjusted basis immediately before death.

For this rule, the property’s fair market value must have exceeded its adjusted basis when gifted. The rule also applies to sale proceeds to which the donor is entitled.

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