10.30.06

Planning for income tax for heirs.

Posted in Planning, Tax planning at 9:52 am by gbroiles

It’s tempting to compare one’s assets to the exemption amounts for federal estate tax ($2 million in 2006, 2007, 2008) and conclude that there are no tax issues in planning one’s estate (or failing to plan).

Unfortunately, that’s only part of the story.

One often underappreciated aspect of estate planning is planning for income tax implications for heirs – ideally, one would like to give heirs assets that are subject to as little tax as possible. Most property that appreciates – for example, real estate, collectibles, and securities (stocks & mutual funds) get what’s called a “step up” in basis when it’s transferred at death.

For example, let’s say that Dad has a share of stock he bought long ago for $10 – the stock is now worth $100. If Dad sells that share of stock, he’ll owe income tax on the $90 of profit he made while holding the stock. The $10 purchase price (which may have been adjusted due to stock splits, reinvested dividends, and so forth) is what tax people call Dad’s “basis” in the stock.

Let’s also assume that Dad wants to give that share of stock to his daughter. If Dad gives that share of stock during Dad’s lifetime to Daughter, Daughter will get what’s called “carryover basis” – that means that Daughter’s basis in the stock will be the same as Dad’s basis, which was $10. If Daughter immediately sells the stock, she’ll also have to pay tax on the $90 of built-in profit.
However, if Dad keeps the stock and gives it to Daughter upon his death – either through a trust, or through a will – then the stock gets the “step-up” in basis, and Daughter’s new basis in the stock is the fair market value on the date that Dad died. This means that if Daughter immediately sells the stock, she’ll have (virtually) no tax to pay, since her basis (fair market value) will be very close to the sale price. Daughter may have a small gain or a small loss on the stock, but it won’t be very big if she sells the stock relatively quickly.

The same treatment applies to other property that appreciates – like real estate or collectibles.

Some property – like cash – is valued at its face value, so it doesn’t make sense to talk about getting a “step up basis” in, say, a bank account.

This sounds great, right? Well, there’s a catch. The only property that gets a step-up in basis is property that’s included in Dad’s “taxable estate” at his death. The good news is that the vast majority of people may have a “taxable estate” but pay no tax, because they get an exemption equal to the tax on the first $2 million of property (for people who die in 2006, 2007, 2008). So .. this means that Dad can pass along up to $2 million in property, all of which gets a step-up in basis for income tax purporses, without owing any estate tax.

If Dad passes more than $2 million in property to others at his death, then his estate will owe tax on the amounts above $2 million – unless the amounts beyond $2 million are given to recipients who have special exemptions. (Specifically, charities and Dad’s spouse, if she’s a US citizen. Charities and spouses who are US citizens can receive an unlimited amount of property at death without any estate tax obligations.)

In my practice, I find that most people notice (and appreciate) the step-up in basis when it is applied to real property. Specifically, the step-up in basis is very helpful to surviving spouses, especially if the shared home was titled as community property. When property is titled as community property, the entire property gets a step-up in basis upon the death of the first spouse.

Let’s say that Mom and Dad bought their house in 1970 for $100,000. Today, the house is worth $1,000,000. (These numbers will look crazy to non-California readers; but they’re not unusual for middle-class people here in Silicon Valley.)

If Mom and Dad sell the house, they’re going to have to pay tax on approximately $400,000 of capital gain – they can exclude the first $500,000 in capital gain when they sell their principal residence, but they’ve got $900,000 in profit – so they’ve still got another $400,000 that they’ll have to pay tax on.

Men tend to have shorter lifespans, so let’s suppose that Dad passes away first. Now – because of the step-up in basis and holding title as community property – Mom’s new basis in the home is $1,000,000. Mom can sell the house and her profit will be zero – so no tax will be due. Let’s say that Mom stays in the house 5 more years – and during those 5 years, the house appreciates another $200,000 in value, to $1,200,000. Mom can still sell the house without having a tax bill to worry about, since she’s got her $250,000 exclusion – applied to the $200,000 profit above Mom’s basis of $1,000,000, there’s still no taxable gain.

But let’s imagine that Mom doesn’t sell the house – Mom lives 10 more years, and the house appreciates in value to $1,500,000. Mom dies, leaving the house to her two kids. If the house is included in Mom’s taxable estate, the kids will get the step-up in basis again – so their basis in the house will be $1,500,000 (or, each kid will have a basis of $750,000 in their half of the house). This means that the kids, if they choose to sell the house, can keep the $750,000 each – with no estate tax, and no income tax due. That’s a pretty nice result, given that Mom & Dad’s original investment in the house was $100,000. $1.4 million in appreciation has passed to the children, tax-free, perfectly legally.

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1 Comment »

Sharron Duncan said,

February 8, 2007 at 6:51 am

Very informative article, HOWEVER, I am the executor of the probate on a home left to me and my sister in Whittier, CA. I live in PA and my sister live in CO. My mother died in July 2004. Being nice, we allowed her husband, who has made no claim to the property and has signed a waiver, to live in the house and grieve for 18 months before going into probate. NOW we are learning from the real estate agent that if we don’t get it sold, through court approval, and close escrow before the third anniversary of her death (July 7, 2007.) which ends the five year clause. She did live in the house since 1951 and for two years of the past five. Only NOW are we learning that we’ll have to pay a 3.3% in taxes to CA if we do not mee that deadline. My probate lawyer is saying he checked with IRS and State Franchise Tax Board and he thinks we are exempt BUT did say he is not a tax expert. What can we do? I have read the IRC 121 which takes me in circles. Frustrating is not even a word to describe the rollercoaster we are on! We knew the estate was under the amount to be taxed but no one mentioned a 5-year deadline!

California Estate Planning Blog

10.30.06

Planning for income tax for heirs.

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