Better to Keep Assets In Your Estate When You Die?

Better to Keep Assets In Your Estate When You Die?

If you’re a high net worth individual or family, chances are your estate planning strategy has focused on finding ways to exclude assets from your estate in order to minimize estate transfer taxes after you pass away. Gifting low-basis property while alive together with the use of bypass trusts after death are common ways to implement such a strategy. But there’s always been a tradeoff: assets transferred through the estate of the deceased owner get a step up in basis, while assets transferred outside the estate keep their original basis. The American Taxpayer Relief Act (ATRA), passed in 2012, significantly increased the exclusion amount for federal estate taxes. Do the tax consequences of passing on low basis assets now outweigh the benefits of sheltering those assets from possible estate taxes?

First, let’s examine the changes created by ATRA. The unified estate and gift tax exclusion amount rises to $5.34 million in 2014. Estates valued at less than this amount pay no federal estate tax. ATRA additionally introduced the concept of exclusion portability, effectively doubling the exclusion to $10.68 million for married couples. At this level it’s estimated that well over 98% of all households will be entirely exempt from any federal estate taxes whatsoever. For higher-valued estates, the tax starts at 18% and rises to a maximum of 40% when the estate’s value exceeds the exclusion amount by $1 million or more.

Although gifts and inheritances are tax free, income taxes will apply when your beneficiaries sell any inherited assets. This is where cost basis comes in. Let’s say your son inherits from you a $1 million house in San Jose. Assuming he receives the property from your estate after your death, its cost basis will be “stepped up” to its market value on the date of your death. If he were to sell the house shortly after receiving title to it, the capital gains tax he’d have to pay would be close to zero since the cost basis would be almost the same as its market value.

Suppose, however, that you had utilized a bypass trust to transfer the house to him. He’d still receive it estate tax free, but in this case the cost basis would remain the price you had paid for the property when you had originally purchased it. If you had bought it thirty years earlier for $100,000, and your son were to sell it after he inherits it, he’ll owe tax on a $900,000 capital gain. That could amount to as much as $214,200 depending on his total adjusted gross income (AGI) for that year.

But that’s not all. You also need to consider the impact of your state’s estate tax and your beneficiary’s state’s income tax laws when making the decision whether or not to exclude or to include assets in your estate. In California, the top tax rate is now 13.3%. If you and your son had both been living in California when you died, there would be no additional estate tax impact (since California has no estate taxes). However, your son could owe another $119,700 in state income taxes when he sells your house. Ouch!

I can find no standard formula for determining in advance what the right answer is. One simple rule of thumb is to estimate the beneficiary’s marginal tax rate. In California, the top rates are 13.3% plus 20% (the federal high-income long term capital gains rate) plus 3.8% (the ACA investment income tax), which totals 37.1%. When that number is close to or above 40% (the top federal estate tax rate), you’re probably better off leaving highly appreciated assets in your estate rather than trying to exclude them. Of course, trying to determining your beneficiary’s tax rates the year you expect to die poses just a few challenges.

In the end, proper estate planning may be even more important today than it has been in the past. It’s probably a good idea to raise this question with your financial planner and/or estate/trust attorney as you reevaluate your estate planning strategy in light of ATRA’s changes.


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