One Time Estate, Gift, Generation Skipping Tax Planning Window for 2010 for US Citizens and Non Residents May Close Soon; Time to Act is Now

Once in a Life Time Opportunity. Federal tax planners estimate that the total savings to the government in keeping the estate and gift tax regime in place for the next ten years is $1 Trillion. This is a down payment on the $10 trillion plus estimated budget deficit over the next ten years. This budget reality and the gridlock in Congress will mean that the estate tax is coming back in 2011, if not sooner. Since there is no estate tax in 2010 at the present time, this presents a once in a lifetime planning opportunity. We list them by bullet point, but each of them has a complex set of rules which could hurt you if done incorrectly. You should not do any of these except with your tax planning team.

*Make substantial gifts in 2010. You do not use up any estate tax exemptions for gifts in 2010. Check with your financial planner to make sure your do not need the money. Make sure the gift is not bad for the person who receives it. If gifts total over $1,000,000 per taxpayer, there would be a gift tax.
*Gift Tax Lowest. Gift tax in 2010 is 35% on any amount over $1,000.000 and may be as high as 55% in 2011.
*Make outright gifts to financially savvy grandchildren. There is no generation skipping tax on gifts to grandchildren in 2010. Again, there could be a gift tax.
*Make gifts in certain trusts to grandchildren. There are opportunities with carefully crafted trusts to transfer large amounts to grandchildren.
*Plan Basis Allocations. Redo your estate plan to take advantage of the basis increases we discussed in prior blogs.
*Who Gets What. Make sure your existing plan does not disinherit a spouse or child in 2010 because your plan assumes an estate tax as the way to allocate assets between spouse and children.
*Existing Trusts for Grandchildren. For existing trusts where grandchildren are beneficiaries, next year a distribution to them could be subject to a grandchild tax (generation skipping tax (GST)) at a 55% rate. Solution: carefully plan and make distributions this year out of these existing trusts when the distribution will not be subject to a GST tax.
*Basis over Value. If you have property with basis over value, consider passing on that higher basis now to your heirs. Example: Real estate or business interest has gone down in market value to $2,000,000, but your basis is $5,000,000. If you and your spouse gift the asset now, your heirs will have the $5,000,000 basis compared to a $2,000,000 basis if your heirs inherit the property in 2010. The basis on which heirs inherit property when someone passes in 2010 is the lesser of market value and basis.
*Use Tools That May Go Away. There is talk about prohibiting further use of tools to discount value, facilitate use of insurance trusts and other commonly used methods to reduce estate taxes. Use them now before they go away.
*Overseas to US Resident. A non US citizen and non resident may be able to transfer substantial wealth to relatives in the US with no US taxes. Beware of taxes imposed by the country of the non US resident.

What If? What if you make a large estate tax free gift in February, 2010 and in June, 2010, the Congress reinstitutes the estate tax and makes it retroactively effective back to January 1, 2010? From our survey:

1. No one knows what Congress will do. A $3.5 million estate tax exemption bill passed the House in December with no Republican voting for it and has not been acted upon by a Senate Committee. Since 2002, Congress has been unable to pass a new estate tax law. Best Guess: Congress will not be able to agree on what the estate tax should be, will allow the automatic repeal of the Bush tax cuts to take place and the estate tax will automatically go back to a $1,000,000 exemption phased out for the larger estates and a maximum 55% rate.
2. Could Be Retroactive. Congress may pass a bill in 2010 and make it retroactive.
3. Courts May Prohibit Retroactive Law. Most legal commentators are not predicting whether the courts will allow Congress to make the law retroactive. Past cases permitting such retroactive laws may not apply.
4. More Delay, Less Likely To Be Retroactive. The longer Congress waits, the less likely Congress will make it retroactive.
5. Short Window of Opportunity. If the bill is not retroactive, then those who act now will take advantage of a window of opportunity that may last only two to six months.
6. Gifts Can be Undone. There are planning techniques to deal with a retroactive imposition of the estate tax in 2010. These could include formula clauses, disclaimers, powers of appointment, decanting, and Trust Protectors.
7. Plans Have to Be Changed Anyway. Many plans need to be revised due to changes in the family and also changes in the law.
8. Risk and Reward. You have to decide whether the rewards of lower taxes on the transfer of your wealth are worth potential risks.

Act Now While the Law is Favorable Before it Changes. Review your plan now to see if you should take advantage of these short term opportunities.

No New Death Tax for Real Estate: Tax Deferred Exchanges and Home Occupancy Deduction

New Death Taxes. In our recent blogs we have shown how for many families, the new death tax in 2010 will cause families to pay more taxes when someone dies in 2010 that they would have paid in 2009. This is because in 2010, there is no step up in basis for property received from a decedent, except for the $1.3 million and marital exemptions.

Home Occupancy Exemption. In the past, a person could exclude up to $250,000 from the profit on the sale of their principal residence if they lived there two of the last five years from the date of sale. What is new in 2010, is that the heirs of the decedent can use this $250,000 exemption even though they did not live there.

Dr. Sam’s $250,000. Dr. Sam bought his house in 1981 and paid $100,000. Over the years, Dr. Sam made $100,000 of improvements. If Dr. Sam had sold his house for $950,000, his taxable gain would have been calculated this way: Determine what Dr. Sam paid for the house ($100,000) plus his documented improvements ($100,000), giving him a basis of $200,000. You deduct from his $950,000 sales price his $50,000 of sales expenses (real estate commission, settlement expenses and seller concessions) to determine net sales proceeds of $900,000, giving him a taxable profit of $700,000. You multiply the $700,000 profit times his estimated combined federal capital gain and state taxes of 20% times $700,000, for a total tax of $140,000 ($700,000 times .20 equals $140,000). But since Dr. Sam lived there two of the last five years, Dr. Sam gets a $250,000 exemption from this tax on the sale of his principal residence so that his taxable gain is $450,000 for a combined estimated tax of $90,000, giving him a tax savings of $50,000.

Sally Inherits the $250,000. If Dr. Sam had died in 2009, his house would have received a “step-up” in basis to $950,000, the value at the date of his death in 2009 and his daughter Sally could have sold his residence for $950,000 and paid no federal or state capital gain (assuming state law is the same as federal law). But, with step up in basis gone in 2010, Sally receives the property at its basis of $200,000 and would have to pay the full $140,000 of taxes if she sold it, unless she uses part of the $1,300,000 exemption. But, there is a special exemption in the new 2010 law that allows Sally to use Sam’s $250,000 exemption even though Sally never lived in the property. If Sally does live there for a while, Sally’s time of residence gets tacked on to Dr. Sam’s time of residence.

Tax Deferred Exchange Beats Death Tax. In addition, real estate has another tax break that is not available for stocks and bonds and has only a narrow application for gold. Under Section 1031 of the US tax code, owners of real estate can complete a qualified tax deferred exchange (trade) of their old rental or business real estate for a new (to them) piece or pieces of rental or business real estate and defer indefinitely any gains. The reason 1031 provides for a deferral of gain is that when doing a 100% exchange, the seller of the property never has the right to receive any cash and therefore has not taken any money out of the investment and has only continued her investment in real estate. However, when the investor cashes out, then the investor has to pay the deferred gain from all of the predecessor properties which were exchanges.

Dr. Sam’s Rental Property. Dr. Sam had bought a modest home in 1972 on Main Street for $40,000. When he bought his new residence, he didn’t sell his Main Street home, but kept it over the years as a rental property. Dr. Sam deducted his depreciation on the Main Street rental property so that his basis was reduced to $10,000 when he died in 2010. With the Main Street property now being worth $500,000, Sally could pay nearly $100,000 in taxes if she sold Main Street after inheriting it from Dr. Sam with a basis of $10,000 ($490,000 times .20 equals $98,000 of taxes). Since Main Street is rental property, there is no $250,000 exemption for it, but it is eligible for a 1031 exchange. Sally believes that she could make more money by exchanging Main Street for other real estate. She completes a qualified tax deferred exchange of Main Street and defers all of the gain on Main Street, thereby having almost $100,000 more available to provide her income from the new properties. Under 1031, Sally can continue to do this for the rest of her life and pass these properties on to her children. She could eventually exchange into a very nice house which she later uses (after a period of rental use) as her home. She could exchange into properties where she has virtually no management headaches and a solid income guaranteed by a large national corporation.

Post Mortem Planning. As can be seen from our blogs, there are lots of ways heirs can reduce the impact of the new Death Tax. Since federal capital gain rates are going up, you have to investigate whether a tax deferred exchange makes sense. If you are an heir of property in 2010, make certain that you consult well informed tax, legal, accounting and financial planning professionals to avoid costly mistakes.

Immediately Redo Your Estate Plan to Capture the New Exemptions from Death Taxes; Obtaining Step Up in Basis in 2010

New Set of Death Taxes. For one year, 2010, there is a new death tax. In 2010, there is no estate tax or generation skipping tax that is paid by your estate. Instead, there is the abolition of step up in basis for one year. For most single widows and widowers with money, this change means that there will be higher taxes imposed on their heirs than was true in 2009 when there was an estate tax (click here for last weeks blog). And, the exemptions for the step up in basis tax require different estate plans than the ones that worked prior to 2010. Since most estate planners thought this would never happen, our informal survey shows that the estate plans of most people have to be changed and changed immediately to comply with the new law.

The New Death Tax. For 2010 only, when someone dies who is a US citizen or resident, the heirs of the decedent take the same “basis” in the property as the person who died or the value at the time of death, whichever is lower. Example: Dr. Sam bought 1000 shares of Google stock when it was $100 and when Dr. Sam died in 2010, Google shares were selling for $600 a share, for a gain of $500,000. If Sally, Dr. Sam’s daughter and heir, sells those 1000 shares she will have to pay the capital gain on those shares, which would be $500,000 times an estimated combined federal and state tax of 20% or about $100,000. If Sally waits to sell the shares in 2011, when the combined federal and state capital gain rate may be 35% or higher, Sally would pay $175,000 or more in taxes on just the Google stock.

First Step: Gather Those Receipts. Your first step in 2010 estate planning is to gather in a folder and have someone scan and put in computer storage, everything that proves what you paid for your assets and all improvements you have made on your residence. For estates over $1.3 million, the executor has to report data to the IRS so that the IRS can check up on the taxes the heirs report when they sell the assets they inherited.

Step Two: Capture the $1.3 Million Exemption. For everyone dying in 2010, there is a $1.3 million exemption that your heirs get to add to the tax basis of the property you owned at your death. This means for most Americans, they do not have to worry about this step up in basis problem because they have less than $1.3 million in their estate. This $1.3 million applies to property in revocable trusts or passed by will or without a will. But, it will not apply to assets you gave away or are in irrevocable trusts you do not own.

Step Three: The Big Prize: $3,000,000 Exemption. If you are married, your spouse can have $3,000,000 worth of property exempt from the no step up in basis rule. In 2009, five years after his wife died, Dr. Sam went to a high school reunion, saw Daisy, his high school sweetheart for the first time in 40 years, and they married three months later. Dr. Sam’s estate is worth $5 million, with a basis of $1 million and therefore potentially $4,000,000 is subject to taxes when inherited and sold by Sally. Dr. Sam updates his estate plan and sets up a trust so that when Dr. Sam passes away, $2.3 million goes to Sally in an asset protected trust and $2.7 million goes to Daisy in a trust that pays Daisy only the income for her lifetime. After Daisy passes away (she is 84), the balance goes to Sally. No estate tax because there is none in 2010. Sally has Dr. Sam’s receipts to show the $1,000,000 in basis and Sally receives the $1.3 step up in basis for the $2.3 million she receives in trust. The $2.7 million in trust for Daisy gets a full step up because it uses the $3,000,000 spousal exemption of Dr. Sam. The executor assigns assets that have no basis or have declined in value to the Daisy trust. Dr. Sam’s assets can be liquidated into cash after his passing and there is no federal or state income taxes (assuming the state follows the federal rules and no retirement accounts which generate taxes).

Dr. Sam Remarries but Does Not Update his Estate Plan. Alternatively, Dr. Sam does not know the law has changed or chooses not to update his estate plan. He left everything in his plan to Sally and nothing to Daisy. Sally is only able to find documentation of the basis of Dr. Sam of $500,000. Sally’s basis in the Dr. Sam’s property is $500,000 plus the $1,300,000 exemption for a total of $1,800,000, leaving $3,200,000 of Dr. Sam’s estate subject to capital gains taxes to be paid by Sally of about $640,000 or higher in later years.

Dr. Sam Does Re Do His Plan but they Live Together. As a third example, if Dr. Sam and Daisy lived together and did not get married, even if Dr. Sam left $2.7 million in trust for Daisy, the trust for Daisy would not qualify for the $3,000,000 exemption because they were not married. Daisy or Sally has a large tax bill when they sell assets. There has been a national trend of more unmarried households. The 2010 tax rules may result in more marriages; there is now a $3,000,000 penalty for not being married.

Plan Now. It is time to redo your plan to make sure it reflects what you want and your plan is current with the current law. Many estate advisors thought this day would never come and they now say that Congress will change the law retroactively and wipe out the step up in basis problem in 2010. But, Congress has not solved this problem since 2002 and you should not depend on Congress to do your planning for you.

Circular 230 Disclosure Notice
Pursuant to recently enacted U.S. Treasury Department Regulations, we are now required to advise you that, unless otherwise expressly Indicated, any federal tax advice contained in this document, including attachments and enclosures, is not intended or written to be used, and may not be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any tax-related matters addressed in this document.

For Many with Money, the Temporary Repeal of the Estate Tax Will Increase their Death Taxes

Beware of TV Commentators. A TV financial commentator made the morbid comment this weekend that 2010 is the year to die because there is no federal estate tax in 2010. What he ignored is that the arcane tax law provides that for many with money in 2010, they will actually pay more taxes with the repeal of the estate tax if they die in 2010. So, if you are single or in a second marriage, have between $1.3 and $3.5 million, don’t use dying in 2010 as a tax planning strategy.

Temporary Repeal. Under current law, effective January 1, 2010, the federal estate tax is repealed until January 1, 2011, when the federal estate tax returns with a vengeance with a tax on everything above $1,000,000 and up to a 55% rate. There is legislation pending which would bring back the estate tax in 2010 with an exclusion of $3.5 million for 2010 and the next several years. Congress will probably try to reinstate the estate tax retroactively to January 1, 2010, making the pull the plug strategy for 2010 even a worse idea. More on that in a future blog. The federal estate tax is a tax on the estate of everything above the exclusion amount, except that bequests to your spouse and to qualified charities are federal estate tax free. Also, many states still have an estate tax and some have an inheritance tax.

Step Up in Basis Is a Big Deal. Before 2010, if someone died, their heirs received their property at the market value of the property as of the date of death of the decedent, or an alternate date. In tax talk, this means their “basis” in the property increased and was “stepped up” to current market value.

Dr. Sam Dies in 2009: No Death Taxes. Dr. Sam (a widower) bought a house in the suburbs for $100,000 which is now worth $900,000. The basis of Dr. Sam in his house is $100,000 (what he paid of it in 1981), plus another $100,000 in improvements, for a total basis of $200,000. If Dr. Sam sold his house for $900,000 and assuming it is eligible for the $250,000 homeowner exemption from capital gain taxes, his taxable gain is $900,000 less his basis of $200,000 less homeowner exemption of $250,000 or $450,000 in total ($900,000-$200,000-$250,000 =$450,000). Dr. Sam’s capital gain tax is a combined federal and state rate of about twenty percent (20%) times $450,000 or $90,000. If Dr. Sam had died in 2009, his daughter and sole heir Sally Sue would have received an increase in Sally Sue’s basis to $900,000, the market value of the house as appraised in the estate of Dr. Sam. Therefore, Sally Sue sells the house for $900,000 after expenses and because her basis was “stepped up” to the value in Dr. Sam’s estate, Sally Sue pays no capital gains because Sally’s stepped up basis is the same as what she sold it for. If Dr. Sam’s estate was less than $3.5 million, his estate pays no estate taxes.

Dr. Sam dies in 2010: $160,000 in Capital Gains Taxes. As a way of raising tax money to replace the revenue “lost” from the repeal of estate taxes, Congress also repealed step up in basis for property received from a decedent. So, if Dr. Sam died in 2010, when there is no step up in basis, Sally Sue receives the basis for Dr. Sam’s house of $100,000, assuming Sally Sue found proof of the $100,000. Sally Sue is very unlikely to find the receipts of Dr. Sam to prove that Dr. Sam made $100,000 of improvements. Sally Sue has not lived in the house and the five year period to qualify for the homeowner residence deduction of $250,000 has expired. Sally Sue’s capital gain in 2010 is $900,000 less $100,000 which is $800,000 ($900,000-$100,000=$800,000). With an estimated 20% combined federal and state rate, Sally Sue pays $160,000 in taxes on the sale of Dr. Sam’s house in 2010 if the house is not covered by the $1.3 million exemption. Sally Sue may experience a $160,000 tax increase due to the one year repeal of the estate tax.

Paper Chase Harassment. Sally Sue has the paper chase harassment of trying to find proof of what Dr. Sam paid for his house in 1981, what he paid for his Microsoft stock in 1982 and what grandmother paid for the family cabin in 1932 before she gave it to Dr. Sam. Finding proof of the basis in assets of a decedent will be very difficult. Sally Sue will have to document her claims of her basis to the IRS. The title companies, the stock brokerage companies, and most of the public will go crazy trying to figure out what parents, aunts, and uncles paid for things during their lifetime. But the anal record keeper gets to finally say with glee: “See, I told you never to throw out those papers from the thirties”.

Exceptions & Exemptions. Of course, it would not be the American tax law unless there were exemptions and exclusions. There is a $1.3 million allowance for a step up in basis and an additional $3,000,000 spousal exemption. For people who are not US citizens or US residents with investments in the US, the exclusion is only $60,000. The net effect of this is that if you are single or married with an estate plan that does not capture the spousal exemption, you still have a death tax in the form of future capital gains for your heirs and your exemption is no longer $3.5 million as it was in 2009, but only $1.3 million plus proof of your basis in assets not covered by the $1.3 million. Since many people are widowed when older and most don’t have estates greater than $3.5 million, 2010 is the year when the taxes to be paid by their heirs on their inheritance increased up to $440,000.

Update your Plan. Will your estate plan survive 2010? In the estate plans we have been doing in the last several years, the 2010 temporary repeal is covered. But, many other plans do not cover this. There are new planning opportunities to take advantage of this one year repeal of the estate tax. Call us to go over whether your plan is up to date, uses all of the new exemptions and how you can take advantage of current rules.