Estate Taxes, Gift Taxes and Tax Basis
“Nothing is Certain but Death and Taxes”
-Benjamin Franklin
Estate Taxes
The estate tax, also known as the “death tax” or “inheritance tax”, is a tax on property as it passes from the dead to the living. The estate tax is imposed by both the federal government and as well as several states. If assets are left to a spouse or charitable organization the tax usually does not apply.
What is included in the Estate?
All assets (real estate, stocks, businesses, insurance, etc) that are owned, whatever the form of ownership, at the date of death are subject to estate tax whether or not the estate transfers through probate. The fair maket value of these assets is used, not necessarily what was paid for them or what their values were when you acquired them. The total of these items is the “Gross Estate”.
What is NOT included in the Estate?
Property owned by the decedent’s spouse or others is generally not included in the estate. Lifetime gifts that are complete, meaning the Giver has no powers or control over these prior gifts, are not included in the Gross Estate
For 2008, the federal estate tax is 45% on assets above $2 million per person (see chart below for annual changes).
Above Amounts are in $ Millions. GST = Generation Skipping Transfer
As is shown in the chart above, the estate tax is scheduled to be repealed for one year, in 2010, and unless Congress renews the Tax Relief Act, the rate will spring back to 55 percent in 2011. Any property left to a surviving spouse (if he or she is a U.S. citizen) or a tax-exempt charity is exempt from federal estate taxes.
Who Pays the Estate Tax?
The estate will pay the tax.
When is the Estate Tax Due?
The estate tax return (Form 706) and any taxes due must be filed and taxes paid within 9 months after death. This poses a problem for estates that consist largely of real estate when there is not enough available cash in the estate from life insurance or liquid assets to pay the tax. Although beneficiaries will often get a step up in basis (see Basis below) for appreciated assets when the are sold, you run the risk of being forced to sell assets in a down market to pay the tax due. Proper planning will ensure that there will not be a “fire sale” on assets shortly after a loved one has passed.
Gift Taxes
The other part of the Unifed Gift and Estate Tax system, the gift tax, imposes a tax on transfers of property during a person’s life. A primary reason that the gift tax exists is to prevent people giving away their assets just before dying to avoid estate taxes; hence that tax rate is generally the same as the estate tax rate. For 2007, any gifts over $12,000 per year to any person (other than gifts of future interest in property) are subject to gift taxes.
Generation Skipping Transfer Tax (GST)
The GST is a tax on outright gifts as well as transfers in trust to or for the benefit of persons two or more generations younger than the donor, such as grandchildren. This tax is imposed only if the transfer avoids incurring a gift or estate tax at each generation level. The current GST rate is equal to the highest marginal estate and gift bracket applicable at the time of the gift.
Basis
Under our current system, when real estate or other assets are passed, the heirs receive a step-up in (cost) basis to market value at the time of death (or 6 months later if elected). Highly appreciated assets such as long-held real estate and stocks that are inherited allow beneficiaries to sell those assets and avoid or greatly reduce their capital gains tax liability. For more information on how basis is calculated and applied to real estate visit the section on capital gains.
Under the Tax Relief Act, this step-up in basis changes in 2010: Along with your appreciated assets, your heirs will inherit your original (carryover) basis, increased by a maximum of $1.3 million. That could result in higher capital gains taxes when they sell the assets. But then in 2011 the full step-up in basis returns.
Real Estate Strategy and Decision Making
It’s clear that the tax laws related to wealth transfer are a moving target. The Estate Tax (and other tax rules mentioned above) is becoming a major political issue, along with the tax cuts from Bush Tax Reform Act of 2003. One thing is for certain, regardless of which party or politician is in power, changes will be made to our Estate Tax laws very soon.
The other major unknown in tax and estate planning is life expectancy. When Social Security was passed 72 years ago, life expectancy was less than 70. Now it’s well above that and may continue to rise with advances in medical treatment. As a result, a clear balance must be struck in structuring real estate holdings so that they provide stable income for the retiree / grantor, and preserve and grow equity in the properties.
With the ever-changing tax laws, uncertain life expectancies, and the cyclical nature of real estate and the economy, real estate decisions need to be made in the context of:
- Financial Requirements, present and future, of Current Owners and Heirs
- Tax Implications of Real Estate Alternatives
- Goals and Values of Current Owners (Charity, Gifting, Legacy Plan, etc.)
- Property and Asset Management Responsibilities and Time Requirements
- Risk Tolerance (Vacancy risks, Building Obsolescence, Market Risks, etc,)
- Local Market Conditions and Directions
- Property Management
- Business Management by Owners and Successors (see Family Partnerships & Trusts)