If your spouse passed away and your living trust automatically funded a bypass trust, this post is for you. You may have a capital gains tax problem sitting in that trust right now, quietly growing every year, and your kids will be the ones who pay for it.
The good news: depending on your situation, there may be ways to get assets out of the bypass trust. Let's walk through it.
Back in the day, a bypass trust (also known as a B trust, credit-shelter trust, or exemption trust) created by an A/B trust was standard equipment in almost every living trust drafted for a married couple. Estate planning attorneys included them automatically, the way you'd include airbags in a car. It was the standard practice.
Here's why.
Before 2011, the federal estate tax exemption was shockingly low. In 1997, it was just $600,000. By 2008, it had climbed to $2,000,000 - still not much when you factor in a California home, retirement accounts, and a brokerage account.
Every person gets one estate tax exemption. Married couples get two, but only if they plan for it. And here was the problem: if Husband died and simply left everything to Wife, his $2,000,000 exemption went with him. Poof. Gone. The family was left with only Wife's exemption when she eventually died.
The bypass trust solved that problem. When Husband died, his half of the trust assets went into an irrevocable bypass trust, shielded by his estate tax exemption. Wife could receive income from the trust and, in most cases, access principal for health, education, maintenance, and support. When Wife died, those bypass trust assets passed to the kids - without being included in her taxable estate. Both exemptions used and exempted $4,000,000 from estate tax, instead of just $2,000,000. Estate tax avoided.
It was elegant. And for a long time, it worked.
In 2011, Congress increased the estate tax exemption to $5,000,000 and, crucially, introduced portability.
Portability means that when a spouse dies, the surviving spouse can "port over" the deceased spouse's unused estate tax exemption by filing an estate tax return (IRS Form 706). No bypass trust required.
The exemption kept climbing. By 2023 it was $12,920,000. And as of January 1, 2026, the One Big Beautiful Bill permanently raised the federal estate tax exemption to $15,000,000 per person, indexed for inflation. A married couple now has a combined $30,000,000+ exemption.
The bypass trust, for many families, went from essential to obsolete - practically overnight.
The problem is that millions of living trusts written before 2011 still have mandatory bypass provisions. When the first spouse dies, the trust automatically splits. Half the assets go into the bypass trust, whether you want them there or not. The surviving spouse often doesn't realize what just happened until years later, when a CPA or a new estate planning attorney delivers the bad news.
This is where bypass trusts go from inconvenient to genuinely damaging.
When you inherit an asset: a house, a stock portfolio, or investment property, you get what's called a step-up in tax basis. Your basis in the asset gets reset to its fair market value on the date of death. If your parents paid $100,000 for a home now worth $2,000,000, and you inherit it at that $2,000,000 value, you can turn around and sell it for $2,000,000 with zero capital gain. That's the step-up. It's one of the most valuable tax benefits in the entire tax code.
Here's what most people don't know: assets locked in a bypass trust do not get a second step-up in basis when the surviving spouse dies.
The bypass trust is an irrevocable trust. It's not a "grantor trust" for tax purposes. When the surviving spouse dies, the IRS does not treat the bypass trust assets as part of her estate. Which means no step-up. Step-up for the assets in the survivor's trust, but no step-up for the assets in the bypass trust.
Let's put some numbers on it.
Example: Husband and Wife bought their home in 1980 for $100,000. Husband dies in 2005. The house is worth $1,000,000. Half the house — $500,000 worth — goes into the bypass trust, with a stepped-up basis of $500,000. Wife keeps the other half in her survivor's trust.
Wife dies in 2025. The house is now worth $2,500,000.
Wife's half (in the survivor's trust) gets a step-up to $1,250,000.
The bypass trust half? Still stuck at $500,000: the basis from when Husband died in 2005.
When the kids sell the house, they'll have a capital gain of $750,000 on the bypass half. At a 20% federal capital gains rate plus California's 13.3%, that's a painful tax bill, easily $200,000+.
The longer the surviving spouse lives, and the more the assets appreciate, the bigger the problem gets.
If your spouse has already passed away, and the bypass trust is already funded, your options are more limited than if you'd caught it beforehand. But you're not necessarily stuck.
Here are the main options, along with the trade-offs.
Sometimes doing nothing is the right call, at least in the short term. If the assets in the bypass trust haven't appreciated much since the first spouse's death, the capital gains exposure may be modest. This may be the case if the bypass trust was funded with mutual funds and not real property. But you should make an informed decision. "Doing nothing" should be a choice, not a default.
If the surviving spouse is in poor health and not likely to outlive the assets by many years, the calculus changes - there is more urgency to transfer the assets out of the bypass trust.
Depending on how the bypass trust is written, the trustee may have the power to distribute assets to the surviving spouse outright, or to the survivor's trust. If that power exists and the surviving spouse is also the trustee (which is common), she may be able to move assets out of the bypass trust entirely.
Pros: Assets distributed to the surviving spouse become part of her estate and will receive a full step-up in basis when she dies.
Cons: This has to be authorized by the trust document. Many bypass trusts limit distributions to an ascertainable standard (health, education, maintenance, support) and do not give the trustee unlimited discretion. Distributing assets in violation of the trust terms is a breach of fiduciary duty. And California's Probate Code is not forgiving about that. You need to read the bypass trust carefully — or have an attorney read it — before moving anything.
This is more doable in a one-and-only marriage situation, where the deceased spouse's children are the surviving spouse's children. However, if it is a second or third marriage with kids from separate marriages, this is more difficult and requires careful analysis with your estate planning attorney. The bypass trust is irrevocable - the beneficiaries can't be changed. The survivor's trust is revocable - the beneficiaries can be changed. You could be laying the groundwork for a lawsuit by the deceased spouse's children if you transfer the bypass trust assets to the survivor's trust and then amend the survivor's trust to leave everything to your kids, at the exclusion of your deceased spouse's kids.
California law gives trustees some tools that weren't available a generation ago.
Decanting (Probate Code §19501 et seq.) allows a trustee to distribute assets from an old irrevocable trust into a new trust with more favorable terms - essentially "pouring" the old trust into a new one. If the bypass trust gives the trustee discretionary distribution power, decanting may be an option to restructure the trust in a way that restores grantor trust status and preserves the step-up.
This is not simple. The new trust has to meet specific requirements. You'll need an estate planning attorney for this.
If none of the above work, you can petition the California probate court to modify or terminate the bypass trust under Probate Code §15409. Courts can modify or terminate a trust when its purpose has become impossible or impractical, or when continued administration would defeat or substantially impair the trust's purposes.
With the estate tax exemption now at $15,000,000 per person, a court petition arguing that a bypass trust created to avoid estate taxes on a $1,200,000 estate no longer serves its original purpose is a reasonable argument.
Pros: Can work even when the trustee lacks discretionary distribution power, and beneficiaries can't agree.
Cons: It's court. It takes time, costs money, and outcomes aren't guaranteed.
If your spouse has already passed and a bypass trust was funded, don't ignore it. The step-up in basis issue is real, and your kids will pay for it in capital gains taxes when they inherit.
Here's the short version of what to do:
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