The A/B Tax Trap (Basis Step-Up, Part II)

Welcome back! So last week we reviewed the basics of basis. This week, I’ll explain how your fancy trust, well-crafted to save you lots of estate tax back in the 1990s or 2000s, could actually end up costing your heirs money, due to changes in the law over the past few years. It all comes down to basis (which is why we went over how that works, in the last post.)

You see, a few years back, the federal Estate Tax ‘kicked in’ when someone died leaving a relatively modest estate (in 2001, $675,000; even less before that).  The amount that each person could pass at death without paying tax (what we call the “Exemption Amount”) increased a few times from 2001-2008 (when it was $2 million), but of course real estate values also increased dramatically over that time period, and many people built up substantial retirement accounts such as 401(k)s and IRAs.  Remember, too, that for estate tax purposes, we count not only your real estate and investments, but also any retirement accounts and the proceeds of life insurance payable on your death.  While there was (and still is) usually no tax on assets passed to a surviving spouse,* if all of the dying spouse’s assets (and the dying spouse’s half of joint assets) go to the surviving spouse, then when that survivor dies, his or her estate will include ALL of the couple’s assets.  This could easily cause the survivor’s estate to exceed the lower tax thresholds in effect in the 1990s and early 2000s. And the tax – with a maximum rate of 55% in 2001, declining to 45% in 2009 – was nothing to sneeze at!

So to be sure to minimize these taxes for couples who might be subject to them, estate planners came up with something called an “A/B Trust Plan,” which works like this: When the first spouse dies, instead of their entire estate passing to their surviving spouse, a portion of the estate equal to the Exemption Amount in effect in that year (for example, $675,000 if they died in 2001) is placed into a “B” (or “Bypass” or “Credit Shelter”) Trust, and the rest passes to the surviving spouse (or into an “A” or “Marital” Trust, hence the “A/B” designation). The “A” property would be included in the surviving spouse’s estate (this is necessary to avoid paying tax on it at the first spouse’s death), but the property in the “B” trust, though available for the surviving spouse to use, is NOT included in his or her estate at death (this is accomplished by the design of the “B” trust). This helped to keep the survivor’s estate below the Exemption Amount (or if that’s not possible, as low as possible), by having some of the assets of the first dying spouse “bypass” the estate of the second spouse to die.

Now, however, with the “Exemption Amount” much higher – for 2014, it’s $5.34 million per person – and the ability to increase it further, even DOUBLE it, for a surviving spouse using something called “portability,” the “bypass” procedure is almost always unnecessary, since there will be no estate tax on the second spouse’s death even without it.  But, you may ask yourself, if the assets are simply taken out of the surviving spouse’s estate for tax purposes, then what’s the harm? Why do we have to mess with it?

Well, consider this: anything that is NOT in the surviving spouse’s estate when he or she dies (which, for most couples today with an A/B Trust Plan, will be one-half of their joint assets – perhaps more if the spouse who owned the bulk of the property died first), does NOT get a ‘step-up’ in tax basis at the surviving spouse’s death!  So if the couple had a home, or other assets, that have appreciated in value, and are likely to continue to appreciate in value after the first death, and half of those assets are owned by each spouse, then on the first spouse’s death, his or her half of the assets will go into the “B” Trust. If the surviving spouse then lives for 10 or 20 more years, when he or she eventually dies, the children or other beneficiaries will get a ‘step-up’ in basis on only HALF of the couple’s assets – the half that was in the “B” trust will get no step up. Since it is often more likely that the family home will be sold by the children (or other recipients) after BOTH spouses have died – and also that the children will not have lived in the home for a sufficient time to be able to exclude gain using the ‘primary residence’ exclusion – this could result in a large capital gains tax bill for the children, when the home is sold after both parents have died.

Bottom line: in many cases, the sole reason for using an “A/B” trust plan, back in the 1990s and early 2000s, was to avoid estate taxes at the second spouse’s death. Now, due to changes in the tax laws and increases in the exemption amount, the “A/B” split is often not needed to avoid estate taxes, and it can actually cause a substantial increase in income taxes for the beneficiaries after the second spouse’s death. (It can also create unnecessary administrative complexity for the surviving spouse; however, an A/B Plan can nevertheless be warranted if the estate is fairly large, and/or for certain non-tax reasons.) So if you have an old trust plan (whether a single, joint trust, or two separate, individual trusts), you should have it reviewed TODAY to see if a change could save your beneficiaries a LOT of money!

* If the survivor is a U.S. citizen; different rules apply to non-citizen spouses.

Published in: on November 9, 2014 at 1:10 am  Leave a Comment  

Step right up…

… to understanding one of the most powerful tools we can use in estate planning, to save your loved ones lots of money. The great thing is, because this is an income tax savings, not an estate tax savings (which only helps multi-millionaires), this can work for almost everyone – not just the very wealthy. The key concept is something we call “basis step up.”  In this post, we’ll cover WHAT is “basis” and WHY it’s important. Next time, we’ll explain how and why your old trust could be unnecessarily costing your beneficiaries some, or all, of this ‘step-up’, and how to fix the problem.

What is “basis”? Well, if you buy something for $10, and sell it for $35, you have made a gain of $25, which you have to report on your income tax return, and which usually results in extra taxes, called capital gains taxes. The amount you put into the item you sold is called your “basis” or “tax basis.” This includes what you paid for it initially, and also what you paid to improve it (so, if you buy land for $10,000 and spend $50,000 to build a house on it, your basis in the property would be $60,000). Your gain – what you are taxed on – is arrived at by subtracting your basis from the amount you get for the property when you sell it.  So, if two people sell properties for the same price (say, $100), the one with the lower basis will have a higher gain, and therefore will usually pay more tax.

How does this work, though, with property you get by gift, or inheritance? Since you paid nothing for it, is your basis zero? Nope! If someone gives you a gift, then you get what we call a “carryover” basis – your basis is the same as theirs was. If I buy something for $10 and give it to you, then no matter what it was worth when I gave it to you, or how long you keep it, your basis will be $10. If you sell it for $100 – even if that was its value when I gave it to you – you will have a $90 gain. (Of course this gets more complicated if you pay just a little for something, so it’s really a “partial gift,” but that’s beyond the scope of this overview.)

BUT, it’s different (most of the time) when you inherit property – that is, you get it because someone died and left it to you. It doesn’t matter if you get it because they made a Will leaving it to you, because you were their natural heir, or because their  revocable living trust said that you get it when they die.*  Most of the time, if you get something when someone dies, your basis will be the market value on their date of death. So if they paid $10, but the property was worth $100 when they died, you will have a basis of $100! If you turn around the next day and sell it for $100, you will have zero gain (and thus, nothing to pay income tax on).

This basis step-up can be a great boon to your heirs or beneficiaries. Let’s say you paid $10,000 for a vacant building lot, and spent $40,000 to build a house on it (this was back in the ’60s, when money went a lot further). Your basis in the property is $50,000. But now, in 2014, thanks to inflation and the housing market boom, the property is worth $550,000, and rising. If you sell it, you will have a gain of $500,000. If it’s your home, you may be able to shelter some or all of that gain from tax; but if it’s not your primary home, or if you give it to someone else, such as your children, and THEY sell it, they will have a tax bill of over $100,000. If you leave the property to them when you die, though, they will probably have little or no taxable gain!

Now there are some exceptions to this. For example, you can’t just give someone something the day (or month) before they die, have them will it back to you, and get the higher basis. Also, the basis adjustment works both ways, so if the value goes down between purchase and death, you are stuck with the lower (date of death value) basis, which can mean more taxable gain.

Stay tuned for more about the basis ‘step-up’, and how to get the most out of it for your loved ones when you pass on.

*Some special kinds of trusts do not work this way, but here we are talking about the most common trusts, revocable trusts, which many people create to avoid probate and keep their affairs private when they die or become incapacitated.

Published in: on October 25, 2014 at 11:04 pm  Leave a Comment  

Where there’s a will…

… there’s a way (or so they say). And, in fact, it’s true – almost everyone should have a will. Even if you have a trust. And even if you are young, of modest means, and perfectly happy with the state’s “default” plan for distribution of your property. Here’s why:

What if you have a fully-funded trust, but are killed by a drunk driver, or by medical malpractice? Your estate (NOT your trust!) could become the plaintiff in a multi-million dollar lawsuit, or the recipient of a large settlement or insurance payout. Even if you have a trust, those proceeds would be coming to YOU – and hence, to your estate – not your trust. This is just one example of why the ‘pour-over’ will is an important part of a trust plan.

Or what if you learn that you were named as a beneficiary of someone else’s estate, such as a distant relative or long-lost friend? And then, by a twist of fate, (more…)

Published in: on July 20, 2014 at 11:06 pm  Leave a Comment  

‘Worm Food or Crispy Critter’ Revisited

One of my first posts on here, a few years ago, discussed the issue of legal responsibility and authority for disposition of one’s remains. My conclusion was that the rules and governing law here in Hawaii were less than crystal clear, but that some general principles from other states’ laws, and general common law, might be applicable.

Well, Hawaii has recently enacted new legislation in this area (apparently becoming the 49th state to do so), so now we (and the courts and funeral homes) have clear legal guidance for dealing with potential disputes in this important and emotionally-charged realm. The statute lays out who has the legal priority to make the necessary decisions regarding disposition of a deceased individual’s remains, and – more importantly – also provides a legislatively-sanctioned form that YOU can use to both name an individual of your choice to make such decisions (in lieu of the default priority list, which might give the power to someone you would not elect) and to indicate any specific wishes you may have regarding disposition.

We have the form available and will be happy to help you to complete it. If you are already a client of ours, we will help you make this important addition to your existing estate plan for a nominal charge. (If you are enrolled in our Maintenance Program, the service is FREE. Yet another reason why the Maintenance Program is the best deal in town.)  If you are not already a client, give us a call and we’ll be happy to help you with all of your estate planning needs.

Published in: on October 25, 2013 at 1:12 am  Leave a Comment  

A Trap for the Unwary

A tax trap, that is. If you (1) are married, (2) have a small or moderate-sized estate (under $10 million), and (3) created a trust-based estate plan at any time in the past several decades, chances are that plan could end up costing your children or other beneficiaries a LOT in unnecessary taxes after you die.  Now, this probably does not apply to you if you live in one of a handful of states that imposes a state estate tax with a low exemption amount (CT, DC, ME, MD, MA, MN, NJ, NY, OR, RI, and TN all have exemption amounts for 2013 that are $2 million or less), in which case your planning has probably been designed to minimize those taxes, as well as the Federal estate taxes, and that may save you more in the long run.  But if you live in one of the many states that has no state estate tax (a list of states with an estate tax can be found here), or has an exemption greater than the value of your estate, keep reading to find out why your plan may be in need of a critical update. (more…)

Published in: on June 29, 2013 at 4:57 am  Leave a Comment  

Five Things to Consider Now

The end of the year approaches, and pretty soon we’ll all be busy with entertaining, shopping, and other holiday pursuits. So now’s the time to think about things that you might want to set in motion to provide a little fiscal relief for the rest of 2012 and 2013.

1. Look at your income for 2012. Is this a slow year? If so, think about things that you might have been putting off or avoiding because of their negative tax consequences. If your income is low this year, or you have a lot of deductions, maybe now is the time to take the tax hit from converting some IRA funds to Roth-IRA status, or withdrawing them entirely (if  you would be needing those funds in the near future anyway). If your income is looking low for 2012, consider shifting some deductions into 2013, by putting off expenditures until after the first of the year. Conversely, if it’s looking high for the year, think about additional deductions you might be able to squeeze into 2012, by purchasing items or pre-paying for rent or services in November or December.

2. Consider using the huge estate and gift unified tax exemption that is going to expire at the end of this year. If your estate is over $5 million, or likely to be that large when you die, then now is the time to shift some of those funds out of your estate to your children or other beneficiaries. You don’t have to give them a big check – you can place the funds into irrevocable trusts, that will protect the assets and allow them to be prudently managed, with not only their current value but all future appreciation out of your estate permanently.

3. Update your estate plan, if it hasn’t been done lately. With the extreme uncertainty over what the estate and gift tax laws will look like for 2013, you want to be sure that your planning is flexible enough to adapt to changing laws and rules, and still provide the best results for you and your family.

4. Plan to have a ‘heart-to-heart’ with your family. Why not take time over the holidays, when everyone is together and in a relaxed frame of mind, to discuss your estate planning with family members? It can be a difficult subject to broach, but a pleasant family gathering can be the perfect time to spend a little time explaining to your children the steps you’ve taken to ensure that things go smoothly if something should happen to you. Everyone’s catching up, so make sure they’re caught up on this aspect of your life too. (One way to bring up the subject is to tell your adult children that you’ve made plans for them, and ask if they’ve done the same for their families. Children can use this approach with their parents as well.)

5. Read up on the new 3.8% ‘surtax’ on certain kinds of investment income, and determine the effect it will have on your overall tax bill. Consider whether shifting some of your assets to a different investment vehicle, or converting some assets to a Roth IRA, might eliminate or reduce the ‘bite’ of that extra tax. Here’s one article that provides some ideas, to get you started.

Published in: on October 23, 2012 at 8:48 pm  Leave a Comment  

Zombie Tax – Update

Good news on the “Zombie Tax” front. This summer, the Legislature passed a new law changing the Hawaii death tax laws. Honestly, I haven’t read the law in its entirety (watch this space for a more in-depth update), but basically it changed the amount that can be passed free of Hawaii state estate tax from a fixed, $3.5 million, to a figure that tracks the Federal exemption (which is now $5.12 million, set to return to $1 million on January 1, 2013). So while the Zombie Tax is still (un)dead, at least it is a little easier to figure out, and plan for – you will either have a taxable estate (under both Federal and State law) or you won’t.

Unless you are in a civil union, of course – in which case you can’t claim the unlimited Federal marital deduction, but can claim an unlimited marital deduction for the purpose of calculating the Hawaii estate tax. Hopefully they’ll fix that soon, too – I heard that DOMA was just declared unconstitutional by the Second Circuit, looks like it’s headed to SCOTUS.

Published in: on October 22, 2012 at 4:45 am  Leave a Comment  

The Best of Both Worlds

When setting up a trust-based estate plan, married couples* in Hawaii have always had to decide what to do about their real property that was held in the special tenancy known as “Tenancy by the Entirety,” or “T-by-E” for short. That was because T-by-E property enjoys special protections, including protection from either spouse’s individual creditors. So if a couple owns property in this manner, and just one of them gets sued or incurs a debt, the creditor cannot place a lien on the T-by-E property, or force it to be sold to pay the debt. There are other special properties of T-by-E ownership as well, and together these properties generally make T-by-E the preferred form of property ownership for most married (or civil union) couples. In fact, in Hawaii, ALL kinds of property – even personal property – can be held as a Tenancy by the Entirety.

But in order to put such property into a trust, and gain all of the benefits that trust planning provides (avoidance of probate, privacy, planning to use both spouse’s tax exemptions fully, providing a smooth transition in the event of death or incapacity), the owners had to give up the benefits conferred by the “T-by-E” tenancy. So couples owning T-by-E property have always had to choose between keeping their property in T-by-E (and risking a probate if they should die at the same time, or if the survivor should die before transferring the property into his or her trust, or creating a ‘Transfer on Death Deed’), and putting it into their trust(s) and losing the special benefits of T-by-E ownership.

But now they no longer have to make such a choice. And if you are in this situation, and previously set up a trust but elected not to put your home or other T-by-E property into your trust (or separate trusts), it’s time to reconsider that choice.

Why the change? Because this summer, our State Legislature passed a new law, which allows T-by-E property to be placed into the owners’ joint revocable trust (or, if they have separate trusts, 50% into each spouse’s or parther’s trust), and KEEP all of the protections afforded by the T-by-E form of ownership. To get the benefit of this new law, certain formalities must be complied with. If you put your property into a trust before July 2012, then you will have to transfer it BACK to your names as a “Tenancy by the Entirety,” and then put it back into the trust, to regain the protections of T-by-E. (But that’s not difficult; both deeds can  be prepared at the same time.) It may be necessary to change the name of your trust, and there is certain language that must be included in the deed in order for the new law to apply.

So, if you have a trust, or have been thinking about getting one, and also own real property here in Hawaii (or in one of the other states that recognizes the T-by-E form of ownership), it is definitely worth looking into this new law that allows you to now have “the best of both worlds.”

*This article also applies to civil union partners (who enjoy all of the legal rights of married couples in Hawaii), and those in “reciprocal beneficiary” relationships.

Published in: on October 22, 2012 at 4:21 am  Leave a Comment  

Hot Off the Presses: 2 New Laws

Hope you are all enjoying this lovely Memorial Day weekend. I am, thanks in part to having just learned about two new laws that have been sent to the Governor for signing. Each of these laws, if passed, will make our planning here in Hawaii much easier.

The first of the two actually solves a common dilemma for married couples (and reciprocal beneficiaries) – whether to continue to hold property as “Tenants by the Entirety,” keeping the creditor protection provided by that type of tenancy, or to put the property into a revocable trust, losing the T-by-E characteristics but obtaining the advantages of the trust. If this law passes, then it will no longer be necessary to choose; a couple will be able to put their “T by E” property into their trust (or even separate trusts), and still keep the creditor protection afforded by the Tenancy by the Entirety form of ownership.  (There are a few ‘hoops’ that have to be ‘jumped through’, however, so it is critical that this be accomplished with the assistance of a knowledgeable attorney – among other things, the trust(s) must be named properly, and there must be special language in the property deed.)

Couples who have already placed their property into trust(s) will probably have to re-deed it back into Tenancy by the Entirety, possibly rename their trust(s), and then put the property back into the trust(s), to get the benefit of the new law. Still, it will be great to have this extra option in our planning toolbox here in Hawaii.

The other new statute is yet another “second try” law, a phenomenon that seems to be getting more common. First there was the Asset Protection Trust law, which was horrible when first passed in 2010, and then not-so-bad after the Legislature fixed it up in 2011. Now we have “Hawaii Estate Tax, Version 2.0,” which seems to fix some of the more complicated and difficult-to-implement (not to mention plan for) aspects of the Hawaii Estate Tax (referred to in a previous post as the ‘Zombie Tax’). Although I have only perused it VERY briefly, and much more study is necessary, its major thrust seems to be bringing the Hawaii exemption in line with the Federal Estate Tax exemption, so that we will once again not be a “decoupled” state. This will make planning easier, as the trust provisions that help married couples eliminate tax on the death of the first spouse will no longer have to take into account a Hawaii exemption that could be lower or higher than the Federal exemption.

Now, if we could just get some certainty and stability in the Federal Estate Tax laws, we might be able to relax a little about all this tax nonsense and focus on what’s really important – helping people pass on their legacies, memories, and values to the younger generations.

 

Published in: on May 27, 2012 at 8:57 pm  Leave a Comment  

The Zombie Tax

Years ago, Hawaii had an estate tax, but it was a “pickup” tax – the amount of the tax was offset by an equal credit against Federal tax, so it was not “felt” by the heirs as a separate tax. Then, the credit was eliminated, and the tax went with it.  But in 2010, it rose from the dead, like a zombie, and while it’s not hungry for brains, it IS hungry for a nice, juicy piece of the estate you were hoping to leave to your kids and other beneficiaries.  Here are a few tidbits about this ‘zombie tax':

- The tax ‘kicks in’ when your total estate (which includes all of the property and assets you leave behind, including your retirement accounts and often the full proceeds of life insurance payable on your death) is valued at $3.5 million or more.

- Although Hawaii has no gift tax, due to a quirk in the way the law is written, your heirs may still end up paying Hawaii estate tax on your lifetime gifts, after you die. So you may have to include those gifts when determining whether the tax will apply to your estate.

- The Federal estate tax now has an exemption of $5 million per person (until 12/31/2012).So, you may not have an estate that is taxable by the IRS, but it may still be taxed by the state of Hawaii.

- Although (until 12/31/2012, if not extended) you may be able to use your deceased spouse’s unused FEDERAL exemption (that is, if he or she used less than the full $5 million exemption when he or she died, before you), there is no such “portability” of the Hawaii exemption. So if a couple does not plan properly, some of their total $7 million Hawaii exemption ($3.5 mil/spouse) could be wasted, and tax paid unnecessarily.

- If you (and your spouse together, if you’re married) have property worth more than $3.5 million, and you have will(s) or trust(s) that were prepared before 2010, your heirs may end up having to pay a hefty Hawaii estate tax if you don’t have your documents REVIEWED and UPDATED to plan for this ‘zombie’ tax.

- Properly drafted documents can help you to avoid any tax (even the zombie tax) when the first spouse dies, and to use both exemptions fully, to avoid paying any unnecessary tax.

- There are ways to avoid or minimize the taxes paid (both Federal and State), even you have a very large estate.

So, if you have not had your documents reviewed by an experienced estate planner in the past two years, you should do it now – or the Zombie Tax may devour your estate!

Published in: on August 15, 2011 at 7:35 am  Leave a Comment  
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