The Little-Known Benefits of Upstream or Reverse Estate Planning

Families holding stocks or other assets with a lot of appreciation often overlook an easy way to reduce or eliminate capital gains taxes.

The strategy is for multi-generation families in which the generations are fairly close and trust each other. Known as upstream or reverse estate planning, the strategy works best when the middle generation own the appreciated assets and has more wealth than the senior generation.

The middle generation transfers some of its highly appreciated assets to the senior generation. The transfers are gifts that qualify for the annual gift tax exclusion ($18,000 in 2024). Any additional value avoids gift taxes by using part of the donor’s lifetime estate and gift tax exemption ($13.4 million in 2024).

The senior generation holds the assets for the rest of their lives and in their wills bequeath the assets to the middle generation.

After inheriting the assets, the middle generation can increase their tax basis to then-current fair market values. The result is no one pays capital gains taxes on the appreciation.

Of course, there are situations when upstream estate planning is optimum and others when it isn’t.

Some families use the strategy in anticipation of the lifetime estate and gift tax exemption declining after 2025. The middle generation can use up some of their exemptions now and reduce capital gains taxes by making gifts of appreciated property to the senior generation.

When the senior generation already is wealthy and likely to be subject to estate taxes (especially if the lifetime exemption is decreased in the future), the strategy might not be viable. The estate taxes might be higher than the capital gains taxes or at least be so high that the transactions aren’t worth the effort.

The strategy also isn’t a good idea when the senior generation has used a significant portion of its lifetime estate and gift tax exemption.

The senior generation needs to hold the assets for life. So, the strategy isn’t advisable when a goal is to sell the assets soon, either to raise cash or to avoid a likely tumble in their prices. In most cases, it is a multi-year strategy.

An exception is when the senior generation is in a low tax bracket and would pay the 0% capital gains tax rate.

Of course, the strategy works best when the senior generation is very elderly or for health reasons not expected to live many more years.

But keep in mind that if someone dies within one year of receiving appreciated assets, the inheritor won’t be allowed to increase the tax basis.

The transferred assets would be subject to the creditors of the senior generation. So, the strategy isn’t a good idea if the seniors have significant debt or potential liabilities.

Consider all angles of the senior generation’s finances. For example, the asset transfers could make them ineligible for some assistance programs, such as Medicaid.

The senior generation would have full ownership of the assets. Over time they could decide not to bequeath the assets back to the middle generation. They could decide other siblings or charities need the assets more. Or one of them might become divorced or widowed, remarry, and decide the new spouse or family should benefit from the assets.

It is best to use publicly traded assets, because their value at the different points is easy to determine. Other assets need valuations at each transfer point, and the IRS can challenge the valuations.