One of the most tax-beneficial estate planning changes in recent history was the ability to transfer an unused estate tax exemption from a deceased spouse to his or her surviving spouse.  Introduced by the Obama administration in 2011, this capability, known as portability, significantly changed the way trusts are written to shelter estates from estate transfer taxes.  Unfortunately the operational rules put in place with the change have made implementation somewhat difficult.  The good news is that the IRS has just changed the rules to make it easier for surviving spouses to take advantage of this valuable capability.

Let’s start with some background.  Prior to 2011 trusts were almost exclusively designed to avoid federal estate transfer taxes, which at various times had been impacting as many as 5% of all estates.  You may not have been aware that the estate tax typically kicked in not at the death of the first spouse, but at the death of the surviving spouse.  That’s because there had always been an unlimited marital deduction.  In other words, after the first spouse dies there is no estate tax on any assets transferred to the surviving spouse, regardless of the amount.

When the surviving spouse dies, though, all his or her assets above the exemption amount are taxed at a pretty high rate when the assets are transferred to the heirs.  So trusts were designed to put a certain amount of the assets into a special secondary trust (known as a bypass trust) using the deceased spouse’s exemption.  That way some of the assets get the first spouse’s exemption and some get the second spouse’s exemption.

Since the portability change in 2011, the need to use bypass trusts has been greatly reduced except for the most expensive estates or for families needing to protect inheritances for children from previous marriages.  And there’s a further side benefit to eliminating the bypass trust.  It has to do with potential capital gains taxes that heirs could face when selling inherited assets.  The cost basis of assets put into a bypass trust is based on their value as of the date of death of the first spouse.  If the surviving spouse continues to live for a long period of time afterwards before passing away, the value of those assets – which could be stocks or houses – are likely to have appreciated significantly.  If the heirs want to subsequently sell some of those assets, they could incur a pretty hefty capital gains tax bill.  Under portability, if the bypass trust is no longer needed, the cost basis of all the inherited property is “stepped up” to its market value at the time of the second spouse’s death, greatly reducing such future taxes.

Unfortunately, the benefits of portability have been overshadowed somewhat by the fact that you do not get it automatically.  Surviving spouses have to elect to utilize it or they will permanently lose it, and they only have 15 months to do so.  The election is made through an estate tax return (form 706), but estates with valuations below the estate tax exemption amount (currently $5.49M) do not need to file form 706.  This has resulted in many surviving spouses failing to file and consequently missing the deadline to elect portability.

In June the IRS introduced a new procedure extending the deadline to a full two years for estates not requiring the filing of an estate tax return.  And for estates whose first spouse passed away between 2011 and 2016, portability can still be elected until January 2^nd, 2018.  Although it would have been even better to have made portability automatic, this change will at least make life a bit easier for bereaved spouses dealing with the myriad legal and financial issues associated with the death of a spouse.  It also serves to emphasize the importance of getting professional help from an estate attorney rather than trying to manage this difficult transition on your own.