Many clients understand the basic concepts behind the income tax and estate and gift tax systems. What is less intuitive is how these two regimes interact, and sometimes conflict, when planning across a lifetime. Both tax systems seek to tax economic gains, but they do so from different vantage points. Recognizing how these systems fit together allows for more coherent planning that minimizes unintended consequences and improves long-term tax efficiency.
Income Tax vs. Estate Tax
Income tax is computed and paid annually and captures the taxpayer’s ongoing financial activity, including wages, dividends, business profits, real estate income and capital gains. Estate and gift tax, by contrast, focuses on the transfer of wealth from one generation to the next, whether through lifetime gifts or transfers at death. Both systems are progressive: the highest graduated federal income tax rate applicable to ordinary income is currently 37%, and Massachusetts income tax for the highest earners is imposed at a maximum incremental rate of 9% comprised of a flat 5% rate plus an additional 4% tax, known as the “millionaire’s tax”. The federal estate and gift tax rate is imposed at a flat 40% tax rate once transfers exceed the lifetime exemption amount. For 2025, the federal lifetime estate and gift tax exemption is $13,990,000 per individual (increasing to approximately $15,000,000 in 2026), with an additional annual gift exclusion of $19,000 per recipient.
Although the two tax systems operate at different times, they frequently meet in practice, and particularly for investors and business owners who build wealth through leverage.
Example – Capital Gain Recognition
Consider the following example:
A taxpayer purchases investment real estate for $1,000,000 using $200,000 of Taxpayer’s own capital and $800,000 of mortgage financing. Under income tax rules, your tax basis is the full $1,000,000. Over time, you take $900,000 of tax depreciation, reducing your adjusted tax basis to $100,000. Meanwhile, property values rise and similar assets in your market sell for approximately $2,500,000. You also refinance along the way to access liquidity, increasing your outstanding mortgage balance to $2,000,000.[1]
If Taxpayer sells the property for $2,500,000, your federal taxable gains equals $2,400,000 [$2,500,000 price less adjusted basis of $100,000]. Of this gain, $900,000 represents depreciation recapture taxed at a maximum federal rate of 28.8% (25% unrecaptured §1250 rate plus 3.8% net investment income tax (“NIIT”)), and the remaining $1,500,000 of gain is taxed at the maximum federal capital gains rate of 23.8% (20% long‑term capital gains rate plus NIIT of 3.8%). The resulting federal income tax liability is $616,200.
Massachusetts also generally imposes an income tax on capital gains at a rate of 5%, and an additional 4% millionaire’s tax applies if the taxpayer’s taxable income exceeds $1,000,000.[2] Applying the 5% rate adds $120,000, for a total combined federal and state maximum income tax liability of $736,200 (approximately 30.7% of the gain). If the 4% millionaire’s is applicable to all the gain, the total MA income tax increases to $216,000, resulting in total combined federal and MA income taxes of $832,200 (approximately 34.7% of the gain). It should be emphasized that the seller in this example is liable for $832,200 of capital gains tax but only has $500,000 of cash after repayment of debt ($2.5 million sales price less repayment of $2 million mortgage).
Example – Estate Tax Benefit of Leverage combined with Income Tax Basis Step-Up
Now compare that result to what happens under the estate tax system if the Taxpayer dies still owning the property. At death, the property is included in the estate at its $2,500,000 fair market value, but the $2,000,000 mortgage reduces the taxable estate to $500,000. If the lifetime exemption has been fully utilized, the federal estate tax would apply only to that $500,000 at 40%, resulting in a $200,000 federal estate and gift tax. The Massachusetts estate tax could also apply and equals $80,000 when imposed at the highest MA estate tax rate of 16%.[3] Importantly, the heirs will receive a stepped-up basis to the property’s fair market value, allowing them to ultimately sell with little to no capital gains tax.
Comparison of Sale vs. Holding Until Death:
| Scenario | Income Tax Result | Estate & Gift Tax Result |
|---|---|---|
| Sell During Lifetime |
Taxable gain of $2.4m • Max federal tax: $616.2k • MA tax (5%): $120k Total Combined: $736k (30.7%) • MA tax w/ surtax (9%): $216k Total Combined: $832k (~34.7%) |
No estate tax impact at the time of sale. The property is no longer included in taxpayer’s estate. The maximum capital gains tax of $832k does have some minimal benefit in that it reduces the ultimate taxable estate. |
| Hold Until Death | Heirs receive stepped‑up income tax basis; little or no capital gains tax upon ultimate sale by heirs. | Estate tax applies only to net equity ($500k × 40% = $200k of federal; potential MA tax of $80k) |
In other words, federal income tax captures gain based on the property’s gross value while estate tax focuses on net equity after liabilities. Leveraging debt can accelerate growth and provide income tax benefits during life but can also affect liquidity at the time of sale. To illustrate, taxpayer, in the earlier example, sold the property for $2.5 million, but received only $500,000 after repaying debt, which is significantly less than the maximum combined federal and MA income tax of approx. $832,200. Estate tax planning, by contrast, measures what remains after debts are settled and this additional leverage may offer meaningful estate tax advantages, especially where decedent owns valuable real estate.
Example – Sale to Intentionally Defective Grantor Trust
Expanding upon the above example, suppose instead that Taxpayer sold the same property, worth $2.5 million and subject to $2 million of debt, to your “intentionally defective grantor trust” (“IDGT”) in exchange for a $500,000 promissory note. For income tax purposes, this sale is disregarded because the trust and the grantor are viewed as one and the same. Therefore, no income tax gain is recognized, and there is an added benefit of grantor continuing to pay the trust’s income tax after the sale (further depleting the taxpayer’s estate). For estate and gift-tax purposes, however, the transaction is respected: only the fixed-value $500,000 note remains in the grantor’s taxable estate, effectively “freezing” the estate’s value while allowing the trust to capture all future appreciation.
Notably, this IDGT structure can facilitate powerful income tax planning. The grantor of an IDGT typically holds a power of substitution (under IRC Section 675(4)(C)), permitting the exchange of assets of equivalent value between the grantor and the trust. Shortly before death, the grantor may substitute cash (or other high basis property) in exchange for the IDGT owned low-basis real estate, ensuring that the highly appreciated real estate receives a full step-up in basis at death. Importantly, this substitution must occur during the grantor’s lifetime; once the grantor dies, the grantor trust terminates and the power of substitution no longer applies.
When administered properly, the IDGT allows the same property that would have otherwise triggered $832,000 of income tax upon sale to be transferred back to the grantor while simultaneously reducing the taxable estate with another equally valuable asset substituted into the grantor trust. The use of the IDGT in this example exemplifies how coordinated planning across both tax systems can yield compounded benefits: deferring income tax during life while minimizing estate tax at death.
Summary
Integrating the two tax systems, rather than treating them in isolation, helps avoid inconsistent results. Since all clients and situations are unique, it is important to strike the right balance, minimizing income tax during life while positioning assets so that future wealth transfers occur as efficiently as possible. For investors and business owners, that means thinking not just about the next tax year, but also about how today’s strategies will shape tomorrow’s estate.
If you would like to review how your current tax strategy aligns with your long-term estate planning objectives, we would be pleased to help assess potential opportunities. Coordinating tax decisions across both systems can help preserve flexibility, manage risk and support a smoother transfer of wealth to the next generation.
The attorneys at Wilchins Cosentino & Novins have the experience and knowledge to assist you with effective tax planning and estate planning. We welcome the opportunity to meet with you and your other trusted advisors to discuss your concerns and goals to develop and implement effective income tax and estate tax strategies.
Attorney Daniel Haies offers clients extensive experience spanning three of WCN’s practice areas including Private Client Services, Business Law and Real Estate Law.
This article is not legal advice and should not be taken as such or relied upon as legal advice.