Posts Tagged ‘stepped-up basis’

Even With No Estate Tax, Some Tax May Be Due on Inheritance

JUNE 9, 2014 VOLUME 21 NUMBER 21

Our clients are often confused about whether their heirs will owe any taxes on the inheritance they are set to receive. We don’t blame them — it’s confusing. Let us try to reduce the confusion.

The federal estate tax limit was raised to $5 million and indexed for inflation in 2011. That means that a decedent dying in 2014 can leave up to $5.34 million to heirs with no federal estate tax consequence at all. It is easy to double that amount for a married couple. And in 2006, Arizona eliminated its state estate tax — so there is no Arizona tax to worry about. That means that there is simply no tax concern for anyone not worth $5 million or more, right? The 99% can pass their entire wealth to their children without fear of tax consequences, right?

Of course that’s not right — it would be way too simple if that were the case. The world — at least the political world — seems to dislike simplicity as much as the physical world abhors a vacuum. Even if your estate is modest, you need to be aware of the tax consequences of leaving money to your heirs. Here are a few of the more common ways your estate might be subject to taxes on your death:

Living, and dying, somewhere other than in Arizona. About half the states, like Arizona, have no estate or inheritance tax. But that means that nearly half of the states do have a tax; some states tax the estate, and some the recipient of an inheritance. Before federal estate tax changes in 2006, it was possible to generalize about those state estate tax regimens — they tended to look alike. But no more. You need to worry about state estate taxes if you live in one of those states with a tax, if you own real estate in one of those states, or if you have heirs who live in one of those states. The details can be mind-bogglingly complex, and they are beyond our scope here. There are plenty of online resources to look up state-by-state rules — we tend to favor this 2013 article from Forbes magazine, partly because it is engagingly titled “Where Not To Die in 2013.” The information is already a year old as we write this, but not that much has changed, and it will give you a good head start.

Owning retirement accounts. You sort of knew this one already, right? You have an IRA, or a 401(k), or a 403(b) retirement plan, and you’ve named your children (or your spouse, or your helpful neighbor) as beneficiary. But keep this in mind: if you leave, say, $100,000 in an IRA to your children, they are going to receive something more like $70,000 of benefit. With careful planning, they can delay the tax liability — but they will pay ordinary income taxes on what they withdraw. Income tax will be paid by anyone receiving the retirement account (except a charity, of course — they pay no income tax), and at their ordinary tax rates. You might have arranged to minimize your own withdrawals, and pay a very low tax rate on the income you do take out — but your daughter the doctor and your son the architect might pay a much higher tax rate and have to start taking money out of the account immediately after your death.

What can you do about that issue? If you have charitable intentions, you can name a charity as beneficiary of your retirement account. You can leave it to grandchildren, who might pay a lower tax rate (and have more immediate use for the money). You can create a trust that forces your heirs to take the money out very slowly. But at the end of that process, some significant income tax is going to be paid by the recipient of your IRA or other retirement account.

Having income-producing property at your death. Arizona does not have an inheritance tax, so there is no tax cost to receiving an inheritance. Except that sometimes there is a small cost. If you leave an estate including, say, stocks and bonds, or mortgages secured by real estate, or anything else that receives income, your estate may incur a small amount of income tax liability during its administration. That can be true even if you create a revocable living trust, since it will typically take 6-12 months to settle even simple estates. But rather than your estate paying the income tax liability, it usually is passed out with distributions to your heirs. So when your daughter hears that there is no tax on her inheritance, she may be surprised when her accountant tells her she owes income tax on a few hundred — or thousands — of dollars of that inheritance.

Having property that has appreciated since you received it. Income tax is usually due on the gain in value of an asset during the time you held it. Most people realize, however, that when you die most or all of your property receives a “stepped-up” basis for calculation of capital gains. That means that your heirs usually do not pay any income tax on the increase in value during the time you owned property.

But be careful — that is not always true. If you gave the property away before your death, or you inherited it in a trust (like a spousal credit shelter trust), it might not get a stepped-up basis. That can mean that the property your heirs receive carries a significant built-in income tax liability. It might not be due immediately on your death, but it might limit their choices about when to sell or give away the property. This is much more of a problem today than it was just a few years ago — with the proliferation of A/B (credit shelter, or survivor/decedent’s) trust planning in the past three decades, a lot of property is now held in trusts and will not get a stepped-up basis on the surviving spouse’s death.

Owning an annuity. You might have done some clever tax planning by buying a tax-sheltered annuity five years ago. But if you die holding that annuity, your heirs might have to pay the income tax on the income accumulated during the years you have held the annuity, and they might have to pay it immediately. Note that tax-sheltered annuities are not called tax-free annuities — they are just a mechanism to delay the income tax liability to a later date when, one presumes, your tax rate might be lower. If your currently-employed children step into your shoes, that assumption might turn out to have been incorrect.

Planning options.  What can you do if you fit into any of these categories? If we are preparing your estate plan, we will talk with you about the issues. Any capable estate planning attorney should be able to see whether you have issues to be concerned about. But that is why we always ask you for detailed information about your assets, your family and your circumstances. Yes, the estate tax regimen has gotten simpler — but that doesn’t meant that the decision-making is necessarily simple.

Joint Tenancy with Right of Survivorship, or Community Property?

MARCH 24, 2014 VOLUME 21 NUMBER 12

Which is better? How should we take title to our house? How about our brokerage account?

These questions are really common in our practice. The answer is actually pretty straightforward, but we do need to lay a little groundwork.

Arizona is a community property state. That means that property held by a husband and/or wife is presumed to belong to them as a community. That presumption does not apply if the property existed before the marriage, or was received by a gift or inheritance. There are special rules for property you owned in a non-community property state before you moved here. It’s also possible for a married couple to enter into an agreement that changes the nature of community property, but those agreements are relatively rare.

Historically, there was one great disadvantage to community property ownership, and one great advantage. That is, there was one advantage and one disadvantage if you assume that the couple would never get divorced. If you have substantial separate property and are considering turning it into jointly-held property, is that advisable? That question is beyond our short essay today, and the answer depends on your comfort level with your spouse and marriage. We’re not particularly accomplished marital counselors, and we don’t have any facts for your personal situation.

But assuming you and your spouse live together more-or-less-happily until  one of you dies, here are the competing considerations to holding property as community property:

Advantage: Income taxes. Upon the death of one spouse, property held as community property takes on a new “basis” for calculating future capital gains. If you have stock that you bought at $1,000 and that you now sell for $10,000 (congratulations!), you have “recognized” $9,000 of gain and will pay income taxes based on that amount. But if you held that property in joint tenancy with your late spouse, it got a step-up in basis to his or her date-of-death value; assuming the stock was worth $10,000 on that day, your income tax is only on $4,500 of the total gain. But if you had held that stock as community property with your late spouse, there would be no capital gains tax on the sale at all.

Disadvantage: Probate. Until 1995, community property could not pass automatically to the surviving spouse. That meant that a probate was often required to transfer the deceased spouse’s community property interest to the surviving spouse. Since no probate was required for property held in joint tenancy (the “right of survivorship” part of joint tenancy means the surviving joint tenant receives the property without having to go through the probate process), most married couples opted for joint tenancy rather than community property.

In 1995, the Arizona legislature made the disadvantage to community property disappear — they created a concept of “community property with right of survivorship.” That means a married couple can have it all: they can get the full stepped-up basis for income tax purposes, but avoid probate, on the first spouse’s death.

Does that mean that all property should be titled as community property with right of survivorship? Almost, but not quite. There are a handful of problems that occasionally crop up and have to be considered:

  • Not every married couple intends to leave everything to one another. You can still get the full stepped-up income tax basis and leave your share of community property to someone else — your children from a prior marriage, perhaps, or another family member. In such a case it might make sense to hold the property as “community property” (with no right of survivorship) but have a will or trust to make provisions for each spouse’s share.
  • The income tax benefit does not always appear. Note that the benefit is not a direct tax savings, but only a potential savings. If you get a full stepped-up basis on property that you then hold until your own death, you haven’t really saved any tax money. But the community property benefit just might give you flexibility — you can decide to sell property after your spouse’s death on the basis of good investment advice, rather than the tax effect.
  • The option only applies (this is obvious, but we need to say it) to married couples. “Community property” is not available to anyone else. Is it available to same-sex married couples? We think so (see our articles on the subject over the last few months here, here and here), but we might turn out to be wrong about this.
  • The benefit may not even be necessary for some assets. No growth in your brokerage account? No benefit. You invest only in municipal bonds and certificates of deposit? Minimal to no benefit. But here’s the big one: most people’s biggest growth asset is their home — and there’s already a substantial ($250,000) exemption from capital gains taxes for a single (widowed) person selling their home.
  • Have you already established a trust as part of your estate plan? You may not need to go through the analysis, since the practical effect of your plan may be the same as the benefit of community property with right of survivorship — or better. Ask your estate planning attorney to review this with you.
  • There are sometimes costs to making the change. For real estate, you will need someone to prepare a deed (you can probably get it right on your own, but it makes sense to hire a professional). In addition, there are modest costs to record the new deed.
  • This only applies to Arizona property. No problem with your brokerage or bank account — they are Arizona property if you live here. Your vacation cottage in Montana, or your Mexican condo held in a land trust, are a different matter. But if your vacation cottage is in Alaska, or California, Idaho, Nevada or Wisconsin, you might be able to do something similar. Ask a local lawyer about the possibility.
  • We need to reiterate: if you have separate property and transfer it to community property with right of survivorship to take advantage of income tax benefits, you may have made a gift of half of your separate property to your spouse. Be careful, and make sure you know what you’re doing.

What’s your bottom line? Should you change everything you own from joint tenancy with right of survivorship to community property with right of survivorship? Maybe, but your home is the least urgent thing to tackle. Your brokerage account? Absolutely. Your summer cottage in another state? Check with your lawyer and ask her (or him) to find out whether the other state has community property with right of survivorship.

Note that none of this really helps you deal with retirement accounts, IRAs, 401(k) accounts, separate property you brought from another state or your complex estate planning intentions. For those, you really need to talk with your lawyer. Also, please be clear: we do not know the correct answer if you live in a state other than Arizona — talk to your local lawyer about that.

 

Simple Estate Planning for a Married Couple

AUGUST 12, 2013 VOLUME 20 NUMBER 30

Last week we saw a married couple in our office. The couple had come to us for estate planning. They did not have children with disabilities, or spendthrift sons-in-law or daughters-in-law. Their assets were not unusual (some Arizona real estate, a brokerage account, several bank accounts). Their net worth was well under the $5.25 million that would have made us want to talk about federal estate tax issues. They intend to leave their estates to one another and, on the second death, to relatives and a few charities. In short, they were a pretty typical couple.

This couple already held everything they owned as “joint tenants with right of survivorship.” That, of course, means that on the death of the first partner, the survivor would receive everything without having to go through the probate process. Ordinarily we would have told them that they ought to have fairly simple wills and Arizona powers of attorney. We would have suggested that they transfer all their real estate and brokerage assets into “community property with right of survivorship.” That’s a slight improvement on joint tenancy because on the first death the survivor gets a stepped-up income tax basis on the entire value of assets held as community property. It is an option that is only available to married couples, and it’s usually worth considering.

Though our couple was married, they did have one legal issue that complicates their estate planning. They are both of the same gender. They got married in another state, where same-sex marriages are recognized, and then retired to Arizona. They are looking forward to enjoying the sunshine, outdoor recreation opportunities, and casual lifestyle of The Grand Canyon State. Though Arizona was once known as The Valentine State (do you know why?), our state Constitution expressly invalidates this couple’s marriage.

Or does it? They have arrived in Arizona at a time of legal ferment. The U.S. Supreme Court has invalidated a federal ban on same-sex marriages; is invalidation of Arizona’s ban (and those in place in dozens of other states) far behind? And, more importantly for our couple, what are legally married gay couples supposed to do in the meantime?

Reasonable minds can differ on what our couple should do. In fact, we are fond of saying that if you get ten lawyers in a room and discuss legal issues, you will get at least twenty firmly-held, well-reasoned opinions. But here is what we discussed with our clients:

  • Consider creating a joint revocable trust. Declare in the trust that everything you own is community property, and file any future tax returns on that assumption. The worst that could happen would be that the IRS ultimately disagrees, and then you are back where you would be if you did nothing of the sort. BUT note that the establishment and funding of a trust is more expensive (by, perhaps, a factor of three or four), and opposite-sex married couples don’t have to go through this kind of silliness.
  • At least create reciprocal wills, and guard them more carefully than opposite-sex couples need to. If a couple whose marriage is recognized in Arizona never get around to making a will, or misplace their wills, it is likely that the default rules will follow what they wrote in their wills. If the marriage is not recognized, though, a missing will could mean biological family members of the deceased spouse take in preference over the surviving spouse — or at least that litigation is required to establish the validity of the out-of-Arizona marriage.
  • Critically important for gay couples, married or not, is signing of a document directing funeral arrangements and disposition of remains. Time and again we have seen same-sex partners shut out of funeral and burial arrangements, even by family members who professed affection for the surviving partner in the hours before death. The advent of same-sex marriages might turn out to have eased that kind of pain, but it may be yet another opportunity for litigation, and at a time of high emotional fragility.
  • Go ahead and try putting real estate and brokerage accounts in “community property with right of survivorship.” Expect a little different experience between stockbrokers and the County Recorder; the former is probably used to same-sex community property declarations, and the latter probably thinks it has a responsibility to uphold Arizona’s misguided law. Do you want to be a little bit subversive and act as an agent for positive change, albeit a small change? Talk with us — we like both of those ideas.
  • Review and update your plans more often than other couples need to. We usually counsel that estate plans have about a five-year life, and we expect to actually see clients again in about 7-10 years. Same-sex married couples ought to shorten that to 3-5 years, as there will be changes AND we want to have recent documents in the ultimate time of need (that’s a not-very-disguised euphemism for “when you get sick or die”).

We were very chagrined to have to advise this delightful couple that Arizona is so unwelcoming. We really want to help them secure the benefits of their marriage in Arizona. We can accomplish almost everything that an opposite-sex married couple can get with their Arizona-recognized marriage, except for the (admittedly small) income-tax benefit of “community property with right of survivorship” titling. But we can’t really tell our couple that they have a moral or legal duty to carry the torch for change in this arena, because the reality is that the benefit is modest for most couples. That’s because:

  1. Your real estate may well appreciate during your life, but if the only real estate you own is your residence then you already get a significant income tax avoidance opportunity (up to $250,000 in gain) without regard to your marital status. Be careful about relying on this as your sole tax-avoidance technique, but for most people it means that they will not ever pay taxes on increases in their home’s value anyway.
  2. Although capital gains in your stock holdings do not have the same partial exclusion opportunity, it is still easy to avoid paying income tax on the increased value by simply not selling the stocks. That means that an “unmarried” couple like our clients would have lost flexibility, not cash — still a negative, but not with as obvious a dollar cost.

For our part, we are looking forward to a time (we hope that it is soon) when these kinds of distinctions are no longer necessary. Meanwhile, we wish the very best for all our clients who have retired to The Valentine State.

 

Arizona Community Property Is Not Always Subject To Probate

OCTOBER 9, 2000 VOLUME 8, NUMBER 15

Arizona is one of nine “community property” states in the country, and that can be the source of some confusion about estate planning, taxes and property ownership rights for married couples. Recent changes in Arizona’s law make the “community property” designation a little more friendly and understandable, and the benefits to this unique property ownership choice are now clearer.

“Community property” concepts were not part of the English common law. Under the system imported to most of the American states, property was owned by one spouse or the other, though the non-owner might acquire some rights in his or her spouse’s property. The French and Spanish, however, understood the marital community to be a separate entity from either spouse individually, and permitted the “community” to own property. Each spouse then holds an equal interest in the community’s property.

Those American states with rich Spanish or French histories tended to adopt some version of the community property concept. Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin are community property states, although the method of implementing the concept varies somewhat. Alaska also permits some trust assets to be held as community property.

In community property states a married couple is presumed to hold assets as community property regardless of the actual title on the asset. Couples may, however, choose to hold their property in joint tenancy or as tenants in common if they wish.

One important advantage to having assets titled as community property comes, oddly enough, from federal tax law. Although capital gains taxes are ordinarily due any time an appreciated asset is sold, the increased value of property held by a decedent at the time of death is not taxed. The property’s income tax “basis” is said to “step up” to its value on the date of the owner’s death, often resulting in substantial income tax savings for heirs.

Jointly owned property only receives a partial “step up” in basis. Property held in joint tenancy will usually only get half the income tax benefit on the death of one joint owner. Community property, however, is treated differently: the entire value of a community property asset gets “stepped up” to the value on the first spouse’s death, resulting in twice the income tax savings.

The main drawback to holding community property in Arizona has long been the requirement of a probate proceeding to pass the property to the surviving spouse. Although the long-term tax savings can be substantial, the probate costs are immediate and, in most people’s minds, too high. Since 1995 Arizona has permitted married couples the best of both worlds: property can be held as “community property with right of survivorship” and secure the favorable income tax treatment while still avoiding the probate process. The value of this type of property ownership is, of course, restricted to married couples.

One caveat: some commentators, relying on fairly arcane interpretations of the federal tax law, argue that the “community property with right of survivorship” designation could conceivably be found to result in no step up in tax basis at all. So far the federal government has not taken such a position, but there remains some slight possibility of a problem. In addition, the effect of titling separate property as community property (with or without the “right of survivorship” language) has more than just tax effects. In other words, you should consult an Arizona attorney before changing title on your existing assets or deciding how to title a new acquisition.

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