You Paid More Estate and Income Taxes than You Had To. Legal Ways to Reduce or Eliminate Your Taxes. Estate Planning Mistake #8.
April 18, 2016
April 18, 2016 By Roger McClure edited by Ellen Paul
We all know we are supposed to brush and floss our teeth at least once a day and preferably after each meal. Brushing and flossing is usually not fun. It always seems to take too long when you are trying to race out the door to an appointment.
We know when we go to the dentist they will check for bacteria living in our mouths and tooth decay and tell us if we need to replace teeth with implants. There is the horror of root canals, surgery and tooth loss.
Planning to avoid paying too much taxes can be equally annoying. But failure to plan can result in a loss of 30 to 50% of your estate. We put it off, knowing we should go to the professional to get the problem fixed and have regular checkups.
There is one big difference between taking care of your teeth and tax planning. Teeth cleaning makes sense and tax planning often does not.
Martha wants to make sure her daughter Helen inherits her house without any cost or fuss. So, Martha deeds her house to Helen while Martha is still alive. Martha continues to live in her house as if nothing changed. No will or trust was necessary or no need to mess with some confusing and expensive attorney or CPA.
Martha soon has tax problems. Martha cannot deduct the real estate property tax payment of $5,000 she made on her home because Martha is not the owner of the house. Helen Martha wants to make sure her daughter Helen inherits her house without any cost or fuss. So, Martha deeds her house to Helen while Martha is still alive. Martha continues to live in her house as if nothing changed. No will or trust was necessary or no need to mess with some confusing and expensive attorney or CPA.
Martha soon has tax problems. Martha cannot deduct the real estate property tax payment of $5,000 she made on her home because Martha is not the owner of the house. Helen cannot deduct the $5,000 because Helen did not pay it. When Martha goes to her tax preparer to complain about this, he tells her that she could owe gift taxes of about $150,000 unless she pays him $1500 to prepare and file a gift tax return and $400 for an appraisal of the house.
Martha cannot refinance the house or get permits in her name for improvements.
Martha then dies. Helen goes to sell Martha’s house. Martha paid $100,000 for the house and Helen sells it for $500,000, after paying all selling costs. Helen has a taxable gain of $400,000 or taxes of about $100,000 to $150,000 on the sale of the house depending upon state and local taxes and Helen’s tax bracket.
Why? Because Martha gave the house to Helen while Martha was alive. If Martha had given the house to Helen when Martha died, Helen would probably pay no federal or state taxes on the sale of Martha’s house.
A key concept in avoiding income taxes on inherited property is the “step up in basis on death”. What this means is that the tax code says: Helen: You are starting over with your ownership of the house when you inherited it and we are going to use the appraised current value of the property as your “cost” basis in the house. Basis is what the tax code says is the value at which you are deemed to have “paid” when you acquired the property.
But Helen says: “Mom lived in the house after she signed the deed and I didn’t get the house until she died.” But, this is an example where the tax code does not seem to make any sense; because of this, many people make this mistake. Martha thought she was doing sensible planning that would allow Helen to avoid probate and easily sell the house.
Martha’s basis was $100,000 when Martha bought her house. So, because Martha gave her house to Helen while Martha was alive, Helen took over the basis of Martha and that is why Helen got stuck with more than $100,000 in taxes, completely legally avoidable.
Nancy sets up a revocable living trust and transfers her house to her trust, with Nancy as the Trustee. Even though it is in trust, Nancy can sell the house at any time, use her $250,000 offset against capital gains in the sale of her residence, and deduct her payment of real estate taxes. The trust provides that in the event of the death of Nancy, Nancy’s daughter Betty will receive 100% ownership of the house and will be able to sell it without going through any court process. Because of the language of the trust, the tax law says that Nancy owns it at the time of her death and Betty will be able to sell the house without any taxes, except to the extent the house sells for more than it was appraised for in Nancy’s estate.
With the house in trust, as Nancy gets older and less able to get around, she can add Betty in as trustee. Nancy can stay in her home with Betty arranging for home care of Nancy. As Trustee, daughter Betty will have ability to manage and sell the house as needed by Nancy without falling into any tax trap. The house is still available for Medicaid planning where desirable or to fund the retirement needs of Nancy. When Nancy dies, Betty will not have to probate the house.
In contrast, where a parent deeds part or all of their home to a child, if the child has an auto accident or a financial reversal, then the parent could lose their home to legal actions against the child.
Does this “inherit without any capital gain tax” work for other assets? Yes! The step up in basis rule also applies to stocks, businesses, art and even your beanie baby or gun collection.
The big area where most people dump their unpaid tax liability on their children is in the area of retirement funds such as 401(k) s or IRAs. Your heirs will pay the taxes you did not pay on most qualified retirement funds.
Martha had $400,000 in Martha’s IRA when Martha died. Her daughter Helen is the sole beneficiary as her IRA. Helen cashes in Martha’s IRA shortly after Martha dies. Come tax time, Helen is shocked to find that Helen has to pay $180,000 in taxes on the IRA she inherited.
This is because unless it is a Roth IRA where the taxes have been paid or other similar arrangement, when you put money into an IRA, the IRS gives you a “break” by allowing you to not pay tax on deposits into the IRA. You deposit $100,000 over time and it grows to $500,000 when you retire. Is the tax on the $100,000 (your seed corn) or $500,000 (the crop of corn)? The sucker break you got turns into a big time win for the tax man. You have to pay the highest applicable tax rate for ordinary income and other taxes on the $500,000 and to the extent you do not, your heirs have to pay the tax on everything in your retirement account. To make sure you or your heirs pay up on the entire $500,000, the tax law requires you or your heirs to take out minimum amounts every year or suffer huge penalties.
Nancy sets up a standalone special IRA trust for her granddaughter Bess. Bess is five years old when Nancy dies. Because of the way the trust for Bess is setup, Bess will only have to take out 1/90th of the funds each year from the IRA Bess inherited from Nancy and is able to grow the $500,000 in this IRA to several millions of dollars during Bess’s lifetime. Bess, at age five, has a life changing almost guaranteed generous retirement when she will be in her sixties. Bess’s mother Betty controls the money until Betty is satisfied that Bess will manage the funds wisely and can then allow Bess to take over the management of the IRA.
There are advanced techniques to lower taxes on inherited IRAs. Contact us if this interests you.
The new federal estate tax exemption started at $5,000,000 per person and increases each year by the increase in the Consumer Price Index. In 2016, it is $5,450,000. Estimates are that less than 1% of Americans will be subject to a federal estate tax. If you will not have estate tax, you need to focus your tax planning on lessening income taxes.
Norm has a second marriage and a daughter and a son from his prior marriage, In Norm’s estate plan, he leaves everything to his son and daughter. Because he owns a successful Dental practice, real estate and life insurance, his total estate is $9,000,000. His unused exemption after some gifts is $5,000,000. With his current plan, he is subject to a federal tax rate of 40% of $4,000,000 or about $1,600,000 because he is not taking advantage of his new wife’s exemption. If Norm changes his plan by including his second wife in the plan and uses other techniques, then he could completely eliminate these taxes and his children will inherit a million or more than with his old plan.
There are so many legal tools and techniques to reduce or eliminate estate taxes, you should not end of paying estate taxes unless you have a mega estate. Even with a mega estate, the estate taxes can be greatly reduced. I recently participated in a national broadcast for continuing education for attorneys and CPAs going over most of these techniques and this information is available through our office. We have successfully planned estates where we have saved client families millions in estate taxes.
Please note that some states and jurisdictions such as the District of Columbia have much lower exemptions (only $1,000,000 in DC) than the federal tax exemption and additional planning is necessary for people with property in such places.
Just like having a habit of brushing your teeth, if you have a habit of proper tax planning, you will avoid the mistake of paying more than you are required to pay for income and estate taxes.
Want a tax plan for your estate? Contact us at firstname.lastname@example.org or call us.