Volume 9, Issue 6
The Wealth Advisor
Capital Gains Tax is the New "Estate" Tax
Many of us in the legal, financial and accounting worlds discover our new clients’ well-intentioned, yet disastrous, plans after the fact. The widow has already transferred her house into her children’s names or an inherited IRA is drained to pay for a Porsche. Observing the lost planning opportunity and the financial fallout is universally gut wrenching.
With the federal estate tax rate at historically high levels, many clients are turning their attention away from estate tax as the most pressing tax issue in estate planning and turning their attention to basis issues and the capital gains tax. Many moderate estates no longer are subject to the federal estate tax rate, so advisors and clients are looking at other potential tax exposure when planning their estates. When the estate tax threshold was low and the estate tax rate was high, it was the most pressing estate tax concern. Now that the federal estate tax impacts fewer people, they are realizing that taking advantage of the step-up in basis of assets upon death can save up to 20% of capital gains taxes on those assets. For many, Capital Gains Tax has replaced the Estate Tax as one of the primary tax concerns of estate planning.
Many of your clients probably don’t understand the fundamentals of basis:
Fortunately, numerous opportunities exist to avoid the huge and instant tax bill associated with selling low basis assets outright and for making the most of tax basis rules. Charitable Remainder Trusts, Family Limited Partnerships, Family Foundations, Installment Sales, or trust structures may be appropriate to dispose of highly appreciated assets, lowering the tax bill with reduced tax rates and charitable deductions.
Be sure to ask your clients lots of questions during your counseling interviews so you carefully understand their situation and avoid costly mistakes. If you’re just collecting data via email or a five minute phone call, you’re likely missing planning opportunities and costing your clients significant tax dollars.
1. A step-up in basis is a wonderful thing. Assets get a step-up in basis at death; so, the mom, who wants to makes things simple for her children and avoid her state’s inheritance or estate tax by giving away the family home, is likely creating a huge tax bill.
2. Tax deferred growth is a wonderful thing. Educating beneficiaries before they inherit can keep more money in their pockets in the long run (and their foot off a Porsche’s gas pedal).
3. Tax minimization is also a wonderful thing. Use tools such as the Charitable Remainder Trust (CRT) to dispose of low-basis, highly appreciated assets without setting off the IRS’s alarms and collection agents.
4. Counter intuitively, income tax returns are also a wonderful thing. Always review income tax returns annually. They provide a wealth of information that your clients may not know is valuable to basis management. We have found that if the return is not reviewed and basis questions are not asked, carry over basis and loss carry forwards are never mentioned. Thus, tax planning opportunities are lost. Don’t miss Wall Street corporate takeovers, rental property, and mutual fund red flags.
5. Team work is a beautiful thing as well. Make sure that basis step-up opportunities are always examined. Step-up opportunities will generally require an estate planning attorney’s input.
What You Need to Know:
First and foremost, stock or property needs to be held for longer than one year to avoid gains being taxed at ordinary rates for high-income payers. This is only an issue for those with marginal rates greater than 15%. In other words, if the client's marginal rate is equal to the minimum capital gains rate (15%) there is no practical impact.
Be sure to determine the capital gains tax impact if an asset is sold. Tax planning looks at future years in which income may be reduced (e.g., at the onset of retirement) allowing for a more opportune asset disposition of low-basis stock or property.
The capital gains rate is 20% for income subject to the highest marginal rate of 39.6%; otherwise, it is 15%.
Also, there is the new 3.8% Medicare surtax, effectively jumping capital gains from 15% to 18.8% (at $250k AGI married) or 23.8% ($450k AGI married).
Low-basis stock or property that has high appreciation is a wonderful thing from a wealth standpoint, but can produce very high capital gains taxes.
Many of your clients likely own their own homes. Residential real estate has a $250,000 (single) and $500,000 (married) profit exemption from the capital gains tax with the main proviso that the home has been owned and used as a primary residence for at least 24 months.
And then there’s rental property to consider. Rental property may be entitled to a step-up in basis at the death of one of the spouses. Clients often overlook this benefit.
Installment sales can be used to spread the gains on sales of businesses and rental properties such that gains are spread over a number of years to avoid running up the AGI ladder.
In addition, low-basis stock or real property are ideal assets for Charitable Remainder Trust (CRT) funding because the property passes to the trust at full value and without immediate capital gains tax implications.
In addition, low-basis stock can also be gifted to Family Limited Partnerships (FLPs) and Family Foundations.
Using the FLP discount, the gift tax hit for the distribution is reduced. Of course, this mostly applies only to those families with wealth greater than the unified gift and estate tax credit (i.e., $11 million for a married couple).
Moreover, so long as the surviving spouse is an American citizen, the marital exemption allows unlimited low basis stock and property to be passed tax free upon the owner's death to that spouse. (Lifetime transfers to an American citizen spouse are also unlimited.)
If these assets do pass through a marital transfer, it is vital that the Wealth Advisor Alliance Team (financial advisor, CPA, attorney) execute a plan to address the surviving spouse's estate/gift tax exposure.
And, keep in mind that often times, low-basis property or stock has emotional connections (e.g., a family business, a home or vacation home with sentimental value, or a treasured collection).
Assets get a step-up in basis at death, but most clients aren’t aware of that benefit; so, the mom who gives away the family home or other assets is likely creating a huge tax bill as well as subjecting her home to the creditors and bad acts of her children. In addition, she will be disinheriting any children who are not the recipients of the transfer as to that asset.
Lastly, remember that Porsche? An IRA’s basis is the after-tax balance formed by nondeductible IRA contributions as well as rollovers (after-tax amounts). Earnings on IRA contributions are tax-deferred.
Actions to Consider:
Sellers Johnson Law • 1 Research Court, Suite 450 • Rockville, Maryland 20850 • (240) 988-5530