11.30.06
Posted in Planning, Tax planning at 3:59 pm by gbroiles
(This guest post was written by James Hall, CLU, with assistance from John Upton and Dunham Sherer, Esq.)
Are State (Prop 13) and Federal Estate Tax Laws limiting home inventories for sale, resulting in a permanent commitment to higher prices and unfair capital gains treatment between surviving spouses and senior couples selling their homes? The solution may be federal legislation to eliminate capital gains for seniors by eliminating the current 250,000 per person exemption Capital Gains Tax.
The positive side effects of allowing seniors (age 65) to sell their homes and personally owned commercial property capital gains tax-free are as follows:
- It is fair to all seniors age 65 and older by giving all equal financial options.
- It should increase the inventory of real estate, making the market more competitive.
- It will increase local tax revenues, because under Proposition 13, the property tax base increases by only 2% per year, unless real property is sold, at which point it increases to current market value. Seniors selling tax free will bring in a current market price taxpayer, and raise the property taxation base to current market value.
- It frees up dead equity capital and moves some of it into the free market.
- Help relieve the Proposition 13 constraint upon real estate sales, and as a result develop more property tax revenue without changing the Proposition 13 legislation.
- Schools should be the #1 beneficiary of increased property tax revenue.
Why do some seniors pay huge capital gains when selling their homes while others pay nothing? The reason is a little known part of the 1981 Federal Estate tax legislation referred to as the “Step-Up-In-Basis-At-First-Death.” This provision means that a current surviving spouse can sell their home for any price with no tax obligation at all. Contrast that to a senior couple across the street that will have to pay a 24% capital gains tax on all gain above the $250,000 per person exemption. In many neighborhoods, that can now amount to a tax of $300,000 and much more on the couple, while the current surviving spouse can make the same sale and move on with no tax obligation at all.
A further point is that this step up provision doesn’t only apply to homes. It applies to both halves of the entire estate. This includes commercial property, cash, stocks, bonds – everything. This is clearly special interest legislation for the very rich to eliminate Capital Gains.
The vast majority of Californians owning homes don’t think Estate Tax legislation applies to them. They are wrong. It applies to millions of homeowners in California and in other parts of the country, who may need to sell and realize gains in excess of the $250,000 per person exemption. They aren’t rich and many can’t afford a huge tax at sale. There are an increasing number of neighborhoods where properties have appreciated more than the current $250,000 per person exemption, yet the tax only impacts the couple who must sell, not the current surviving spouse at any age.
A partial equity solution to property tax inequality would be to give equal treatment to senior couples and surviving spouses, at least with respect to real estate sales. The long-term effect of the existing Federal Estate tax legislation is to create an increasing financial incentive for seniors to stay where they are and hold property until a death occurs. It leads to limited inventories, lower potential property tax revenues in older neighborhoods and ultimately higher prices for residential and commercial real estate.
The current legislation has increasingly become special interest legislation that transfers the property and capital gains taxes to middle class homeowners and senior couples who must sell. The effects of this legislation have been over 20 years in the making. The inequities created are obvious. What will the next 20 years bring, with continuing inflation and no change in the current laws, other than increasing inequities among surviving spouses and senior couples?
Is it any wonder why California real estate values continue to rise with special interest legislation that penalizes home and commercial real estate sales by senior couples? Its unfair that some seniors get a capital gains break on the sale of their property and others do not. Eliminate the capital gains tax on property and many seniors will sell at a convenient time, which will increase housing supply and lower prices. The time for legislation to correct these effects on the real estate market is long past due.
James U. Hall, CLU, Monte Sereno
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11.29.06
Posted in Living trusts, Planning, Tax planning, Wills at 8:32 am by gbroiles
Last month, I wrote briefly about Suze Orman’s Will & Trust Kit. After writing that post, I decided perhaps I was unfair by commenting about the program without using it myself, so I ponied up $14 to get a first-hand opinion.
As I mentioned before, the trust(s) created by the program use California law, no matter what state you live in. A joint trust created with this program says that all property transferred to the trust will be community property. A joint trust created by this program also waives each spouse’s rights under California Family Code section 2640. Don’t know what community property is, or what section 2640 says? Too bad.
Briefly, Family Code section 2640 says that spouses have the right to be repaid for separate property they bring to the marriage, or contribute to community property during the marriage - e.g., if you own a house as a single person, then get married, and later get divorced, you don’t need to split the equity you already had in the home at the time you were married.
I think it’s amazing that the program expects people to waive their rights under 2640 without explaining what that means - that’s potentially a decision with consequences in the tens or hundreds of thousands of dollars, in the event of divorce.
Also, many people want to put separate property into a joint trust for ease of management - a well-drafted trust will preserve the separate property character of separate property assets which are titled in the name of the trust. The Suze Orman trust does the opposite.
Before printing any documents, the program makes you agree to a disclaimer that says you should consult an attorney. Unfortunately, if you’re not in CA, it may be difficult to find an attorney who wants to give you a legal opinion about CA law.
The trust included does absolutely no estate tax planning. It’s good that the authors are up-front about this, but it would be helpful if the materials on the outside of the box explained that if you’ve got more than $1 million in property, the authors think you should avoid using their program and see an attorney instead.
Ultimately, to generate an estate plan using this software, you’re going to have to click over and over again to “AGREE” to a disclaimer that tells you these documents should be reviewed by an attorney before they’re actually used; that the authors are not providing legal advice; that the authors accept no responsibility for your actions. Would you hire an attorney who gave you documents while asking you to sign a document agreeing not to sue them if the document turned out to be useless, or worse?
The trust created by the program can be modified entirely after the death of the first spouse - so there is no protection in place to preserve assets for the joint children if the surviving spouse remarries or needs Medicaid-funded nursing home care.
The documents provided to change beneficiaries for IRA and 401(k) plans have no discussion of - and make no provision for - planning for “stretch” IRA distributions, and in fact make “stretch” planning impossible, which might potentially mean losing out on tens or hundreds of thousands of dollars due to the missed stretch opportunity.
Even though the attorney who co-wrote the software is licensed in California - and California is the forum state mentioned in the choice of law clause - the estate plan makes no provisions for California property tax planning for beneficiaries who may inherit real property. If you’ve lived in California, you’ll appreciate the importance of preserving your Proposition 13 property tax assessed value for your children, and their children .. if your estate plan was drafted with that end in mind. There may be similar issues for people who live in other states - I’ve got no idea if there are or not, and you probably don’t either, unless you find someone who knows your local law.
The program doesn’t cost much money and has some educational value. So it’s not a total waste. The plan and the documents it produces are a long way away from what a good estate planning attorney can produce - but what’s really missing here is an overall understanding of the family’s assets, values, risks, and opportunities .. together with a comprehensive plan to address those circumstances.
I’m an estate planning attorney in CA - but I don’t really think of a software package that costs less than a large pizza as a meaningful competitor, especially after trying it out to see what it produces. I wouldn’t mind at all if potential clients of mine used the software to play around at home to get comfortable with some of the terminology and issues that are part of putting together a real estate plan - but there’s no way I’d recommend this to someone I cared about as a good way to create an estate plan that they actually planned to sign and use.
I’m still shocked by the decision to make trusts for all states subject to California law - that’s the kind of advice that can only be given responsibly by someone who understands California law, the law of your state, and your personal circumstances. There are cases where I might choose to have a client’s trust be governed by the law of another state - but those cases are relatively rare, and I can articulate clear, concrete reasons to do so. A blanket choice that everyone, everywhere, should use California law strikes me as inappropriate.
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10.31.06
Posted in Planning, Tax planning at 9:44 am by gbroiles
Let’s continue to consider the example described in the previous post - Mom and Dad buy their home for $100,000 in 1970. Given California’s property tax scheme, as modified by Proposition 13, Mom and Dad will pay state and local property taxes of approximately 1.1% of the assessed value of their home every year - and the assessed value of the home is artificially limited to a growth rate of 2% per year, unless and until the home is sold, at which time it’ll reset to the real fair market value.
In practical terms, this means that Mom & Dad, in 2006, will probably be paying property taxes of between $1,000 and $1,500 per year on their home that’s worth $1,000,000. Let’s imagine another couple purchases the home next door to Mom & Dad, which turns out to be identical to Mom & Dad’s house - and the fair market value (FMV) is also $1,000,000. The new couple will pay approximately $10,000 per year in property tax, where Mom & Dad will pay closer to $1,000.
This ability to retain the old assessed value represents a considerable opportunity to avoid paying property taxes.
An important part of estate planning - often overlooked by attorneys who don’t spend a lot of time working on estate plans, and virtually always overlooked by do-it-yourself software kits and books - is working to preserve the opportunity for heirs to keep the favorable low property tax valuation, in the event that the heirs choose to continue to own the property instead of selling it.
As discussed in the previous message, let’s say that Mom stays in the home after Dad’s passing, and that when Mom passes away the home is now worth $1,500,000. Mom’s estate plan provides that the home will go to her son and her daughter, each taking a 50% interest.
Son and Daughter will get to keep Mom’s favorable property tax valuation; California law provides that property tax will not be reassessed on a transfer between parents and children. The transfer of 1/2 of the property from Mom to Son and 1/2 of the property from Mom to Daughter qualifies as a transfer that’s exempt from reassessment.
Let’s say that Daughter’s already got a house she wants to stay in - but Son wants to live in the family home, so he arranges to get a mortgage so he can purchase Sister’s half from her, and Son can own the home as his own.
The wrong way to set this up is the obvious way - Son buys the other half of the house from Daughter. Now, Son will get to use the favorable valuation for the half of the property he inherited from Mom, since that was an exempt transfer .. but the half of the house that Son purchased from Daughter will be reassessed, because sibling-to-sibling transfers aren’t exempt. Now, instead of paying a property tax bill of $1000 to $1500 per year, Son’s property tax bill will be more like $8000 per year (1/2 of $1,000 + 1/2 of $15,000).
If Son keeps the family home for 20 more years, the failure to plan for favorable property tax treatment will cost Son $140,000 in extra property taxes. If Son then passes the property on to his children at his death, then his kids will be paying property tax bills of $8000 instead of $1000, and the waste continues.
Unfortunately, this approach is what you’re likely to end up with if you (or your attorney, or your do-it-yourself software) aren’t paying attention to property tax planning - it’s easy to conclude “well, there are no estate tax issues here” and stop thinking. That decision to stop thinking can cost heirs an awful lot of money pretty quickly.
This isn’t a hypothetical example - I have worked on several cases where the estate plan was drafted by an attorney (or worse, an annuity salesperson) who didn’t know or care about property tax, and the consequence is tens or hundreds of thousands of dollars in unnecessary property taxes for the heirs.
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10.30.06
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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