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.
To help get the message out and to illustrate the transformation you provide to clients, you are welcome to use the below facts and scenarios in your own educational materials, presentations and conversations. Consider this a “red flag” list of income tax pitfalls and opportunities so you can be your clients’ (and their beneficiaries’) basis management hero.
Many of your clients probably don’t understand: how basis is determined, the step-up in basis at death for both separate and community property assets, and the consequences and opportunities associated with low basis assets. They certainly don’t understand the rules governing when basis applies to IRAs and when it doesn’t, or how to transform separate property into community property to get a full step-up of basis at the death of the first spouse.
Fortunately, there are numerous opportunities 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.
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 marginal rate is equal to the 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%.
And then there’s the 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.
Community Property Trusts for married couples in separate property states are an effective way to get a double step-up in all assets owed by the couple no matter how titled. For larger estates, million of dollars in capital gains taxes can be avoided with this relatively simple trust structure.
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 advisor/estate planning attorney team 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.