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Estates & Trusts

Tax Planning for Trusts and Estates

By Estates & Trusts

As 2020 comes to a close, it is important to consider estate and gift tax planning strategies and to closely review your estate plan.  The article outlines the tax changes from 2020 to 2021 and discusses income tax and estate and gift planning considerations.

Federal Estate Tax.

In 2020, the federal estate and gift tax exemption is $11,580,000. The exemption increases to $11,700,000 in 2021. The value of a person’s estate and/or lifetime gifts exceeding the exclusion amount is subject to a 40% estate and gift tax rate. Further, through a so-called “portability” provision, if a spouse dies after 2010 without exhausting his or her estate and gift tax exclusion amount, the surviving spouse may be able to use the deceased spouse’s remaining exclusion amount against his or her transfers during lifetime or at death by filing an estate tax return within two years of the decedents date of death and making the portability election.

The federal estate and gift tax exemption is scheduled to sunset in 2026 to $5,000,000 (indexed for inflation). The new Biden Administration plans to reduce the exemption even sooner, as early as the beginning of 2021. Careful planning should be considered in order to take advantage of the current exemption before it is potentially cut in half.

 

Federal Gift Tax.

The annual exclusion for gifts remains at $15,000 per person for 2021. Direct payments for tuition and medical expenses are exempt from gift tax. Making annual exclusion gifts is one of the easiest ways to maximize wealth transfers to future generations.

A person is not limited as to the number of donees to whom he or she may make such gifts. Further, because the annual exclusion is applied on a per-donee basis, a person can leverage the exclusion by making gifts to multiple donors (family and non-family). Thus, if an individual makes $15,000 gifts to 10 donees, he or she may exclude $150,000 from tax. In addition, because spouses may elect to apply their exemptions to a single gift from either spouse (“gift-splitting”), married individuals may effectively double the amount of the exclusion to $30,000 per donee. A person may not carry over his or her annual gift tax exclusion amount to the next calendar year.

The annual gift tax exclusion applies to gifts of any kind of property, as long as the gift is of a present, rather than a future, interest. Gifts of appreciated property also could result in income tax savings to the giver, because the recipient would pay the capital gains tax on any sale. Therefore, before giving away appreciated property that is likely to be sold, consider the income tax cost to the recipient.

A special rule allows a contributor to utilize up to five annual gift tax exclusions simultaneously when funding a 529 plan. Thus, for 2020, he or she may fund the plan with up to $75,000 (5 × $15,000), then elect on his or her gift tax return to spread this gift over five years (2020 through 2024). By using five annual exclusions, the entire gift becomes gift-tax-free. However, the contributor must wait until 2025 to make another tax-free contribution to this plan, or any annual exclusion gifts to that individual.

 

Low Interest Rates.

The interest rate is currently at historically low rates. Consider taking advantage of the current low-interest rate environment by loaning or borrowing money. If you have existing family loans, consider restructuring them. In addition, grantor-retained annuity trusts and charitable lead trusts are just a couple estate planning vehicles that become even more beneficial in a low-interest environment.

 

Proposition 19

Under current California law, a property owner can transfer a primary residence and up to $1 million in assessed value of any other property to their children (and qualifying grandchildren) and the assessed value(s) would transfer with the property, thus avoiding property tax reassessement.

With the passing of Proposition 19, the avoidance of property tax reassessment will be drastically limited for property transfers made after February 15, 2021. Under the proposition, only $1 million of assessed value of a property owner’s primary residence can be transferred to a child without triggering reassessment. In addition, the property must be used as a primary residence in the hands of the child for this to work. If you have a property that you plan on keeping in the family for multiple generations (whether it be a primary residence, vacation home, or rental property), consider transferring the property to your child or to an irrevocable trust.

 

Trust Tax Rates

See below for the current tax rates versus the tax rates for 2021.

2020 Trust Tax Table

If taxable income is: Then income tax equals:

Not over $2,600                                  10% of the taxable income

Over $2,600 but not over $9,450        $260 plus 24% of the excess over $2,600

Over $9,450 but not over $12,950      $1,904 plus 35% of the excess over $9,450

Over $12,950                                      $3,129 plus 37% of the excess over $12,950

 

2021 Trust Tax Table

If taxable income is: Then income tax equals:

Not over $2,650                                  10% of the taxable income

Over $2,651 but not over $9,550        $265 plus 24% of the excess over $2,650

Over $9,551 but not over $13,050      $1,921 plus 35% of the excess over $9,550

Over $13,051                                      $3,146 plus 37% of the excess over $13,050

 

Capital Gains

The adjusted net capital gain of an estate or trust is taxed at the same rates that apply to individual taxpayers.

  • A 0% rate applies to adjusted net capital gain that, if it were ordinary income, would be subject to the 10% income tax rate
  • A 15% rate applies to adjusted net capital gain that, if it were ordinary income, would be subject to the 24% or 35% income tax rate
  • A 20% rate applies to adjusted net capital gain that, if it were ordinary income, would be subject to the 37% income tax rate

 

Investment Income Surtax

In 2021, a 3.8% surtax applies to the lesser of (1) undistributed net investment income (NII) or (2) any excess of adjusted gross income over $13,050. Any given item of NII is included in the NII of either the trust/estate or its beneficiary. Distributed NII is NII to the beneficiary as indicated on Schedules K-1, and undistributed NII is NII to the estate or trust.

 

Methods to Reduce Surtax Liability

The 3.8% surtax applies to income from a passive investment activity. To help reduce the amount of income subject to the surtax the following should be considered:

  • For complex trusts, compare the tax with and without distributions to beneficiaries to determine whether the trust or individual is in the lower tax bracket
  • Use Installment Method to spread out gain on sale over multiple years
  • Use like-kind exchanges to defer gains
  • Recognizes losses to offset gains

 

Income/Deductions

Some strategies that can be used to accelerate or defer income and/or deductions are looking at the:

  • Timing surrounding payment of state income taxes and property taxes, keeping in mind the new law limits the aggregate deduction for state and local taxes, including income taxes and property taxes, to $10,000 per year. Property taxes related to the production of income and investment holdings do not fall under this limitation and can be deducted in full.
  • Timing surrounding payment of other trust expenses (i.e. fiduciary, accounting, legal)
  • Revisiting the trust’s distribution strategy to see if more income can be passed out to beneficiaries taxed at a lower rate than the trust

 

Trust Agreements

Review your trust agreement and make sure it still makes sense given the current estate and gift tax regime and the potential changes to the regime in the coming years. Review and update beneficiaries, trustees, and the titling of assets, as needed.

If you would like to discuss these and other year-end tax planning ideas, please contact your L&B Advisor.

 

A Potential Tax Break for Your Inherited IRA

By Estates & Trusts

Inherited IRAs can come with a large tax burden – so large that the value of the IRA may be almost entirely diminished between estate taxes and income taxes. However, there is a little-known deduction that can significantly lower a beneficiary’s tax burden in regards to any income in respect of a decedent. Read more to learn about how you can save a large amount of tax on an inherited IRA with a relatively straightforward deduction.

The death of a loved one can be overwhelming, especially if you inherit various types of assets from the estate that are treated differently for tax purposes. Income in Respect of a Decedent (IRD) refers to untaxed income that a decedent had earned or had a right to receive during their lifetime. This income typically comes in the form of a tax-deferred qualified retirement plan such as an inherited IRA, but can also include other employer retirement plans, inherited non-qualified annuities, employer non-qualified stock options, deferred compensation, and more.

IRD is taxed to both the estate and the beneficiary that inherits the income, which often leads to double taxation.  In extreme cases, this income may be taxed at up to a 77% rate (40% estate tax in addition to a 37% ordinary income tax rate), which essentially diminishes most of the value of the income. However, a rule exists to avoid this double taxation. Typically, a beneficiary must pay ordinary income tax on income before they can receive their inheritance. However, with the IRD deduction (also known as the decedent deduction), beneficiaries are eligible for an income tax deduction on their individual return when the income becomes taxable (i.e. is withdrawn from the IRA account).

A beneficiary can get the decedent deduction on these inherited assets by showing that the estate already paid estate taxes on those particular income items. This deduction must be claimed at the time that distributions, along with the taxable income, are received  from the IRA. However, an important thing to note is that the IRA distributions do not need to be used to pay the estate’s tax liability in order to receive the decedent deduction. The decedent deduction is claimed as a miscellaneous itemized deduction on Schedule A for individuals, but is not limited to the 2% AGI threshold – this means it was not eliminated by the Tax Cuts and Jobs Act.

If you failed to include this deduction when you filed your tax return you can file an amended return for any year within the statute of limitations to claim tax refund.  The statute of limitations is currently 3 years from the date you filed your original return. The decedent deduction can be quite significant in magnitude, so this topic should be discussed with your tax preparer to see if it would be beneficial to file an amended return.  While this deduction has the potential for large tax savings, it may also be difficult to calculate and track.  If you have any questions regarding the decedent deduction, or any other tax matters, please feel free to contact us at (858) 558-9200.

Why Does Title Matter?

By Estates & Trusts

Our assets are very important to us, but have you thought about how your assets are titled? When someone dies, the way assets are titled may affect many things, such as who has access to or will inherit those assets, whether those assets need to be probated, and whether they are includible in your estate. In this article, we will talk about the different ways to hold title and the consequences of those choices.

To begin with, title refers to a legal right of ownership to a piece of property. The different ways to hold a title can, in the event of the owner’s death, dictate whether the asset belongs to the estate and is subject to probate or if the title supersedes the will in favor of distributing to specific beneficiaries.

A common account that becomes part of a decedent’s estate is an individual bank account or sole ownership in property. The individual solely holds title to the account and can use it throughout their lifetime. It is later distributed per the will and subject to probate, which is the legal process to prove the will’s authenticity. To avoid probate, an individually titled account can have a beneficiary designation, commonly known as a payable on death or transfer on death. This type of title holding supersedes a will because a beneficiary is already named to inherit the account. The other benefit of this type of designation is that the beneficiary will have immediate access to this account when you die and will have the ability to use the funds to pay necessary expenses and debt on your behalf of your estate. In addition, the beneficiary does not have access to the account while you are still alive.

In contrast to sole ownership, assets can be held among multiple people through joint tenancy with right of survivorship. The multiple owners, who do not need to be married or related, have full access and ownership of the asset to enjoy and use. When a joint tenant dies, the entire asset gets a step-up in basis (in most cases) and automatically passes to the surviving joint tenants, avoiding probate. In this type of joint tenancy, however, creditors can petition the court to divide the property and force a sale.

Another type of joint title holding is tenants in common, or TIC. This type of title holding allows the holders to own the asset in proportion to the amount they contributed. In contrast to joint tenancy with right of survivorship, the deceased’s interest does not stay with the survivors but is distributed according to the will and subject to probate. A step-up in basis only applies to the decedent’s portion of the property. Creditors can also place liens but only against the specific owner’s portion of the property. A lien is the right to possess property until debt is discharged.

An additional joint ownership title method is a tenant by entirety. This is only available to married owners, who are considered one person. The surviving spouse has the right of survivorship and the title holding supersedes a will.

Assets may also be held in a living trust. A trust is a legal entity established to control assets. The trust is technically held by the trustee whose actions and powers are dictated by the trust agreement. Assets titled under the trust name avoid probate as they are removed from the decedent’s probate estate and placed into the trust. At your death, the trust assets are includible in your estate and receive a step-up in basis. They will then be distributed to your trust beneficiaries as prescribed by the trust document.

As you can see, there are many different ways to hold title to assets. It is important to weigh the pros and cons in order to achieve the desired consequence for specific situations and to take into account possible future events. If you have any questions regarding titles and beneficiary designations, please feel free to contact us at (858) 558-9200.

2019 Year End Planning for Trusts & Estates

By Estates & Trusts

As we are wrapping up the 2019 year, we want to think about things we can do to minimize tax liability on trusts and estates. This article outlines the changes in trust and estate taxation for 2020 as well as some tax planning strategies to consider.

Federal Estate Tax.

Estates of decedents who die during 2019 have a lifetime exclusion amount of $11,400,000. The exclusion increases to $11,580,000 in 2020. The value of a person’s estate and/or lifetime gifts exceeding the exclusion amount is subject to a 40% estate and gift tax rate. Further, through a so-called “portability” provision, if a spouse dies after 2010 without exhausting his or her estate and gift tax exclusion amount, the surviving spouse may be able to use the deceased spouse’s remaining exclusion amount against his or her transfers during lifetime or at death.

Federal Gift Tax.

The annual exclusion for gifts remains at $15,000 per person for 2019. Direct payments for tuition and medical expenses are exempt from gift tax. The annual exclusion will stay the same in 2020. Making annual exclusion gifts is one of the easiest ways to maximize wealth transfers to future generations.

A person is not limited as to the number of donees to whom he or she may make such gifts. Further, because the annual exclusion is applied on a per-donee basis, a person can leverage the exclusion by making gifts to multiple donors (family and non-family). Thus, if an individual makes $15,000 gifts to 10 donees, he or she may exclude $150,000 from tax. In addition, because spouses may elect to apply their exemptions to a single gift from either spouse (”gift-splitting”), married givers may effectively double the amount of the exclusion to $30,000 per donee. A person may not carry over his or her annual gift tax exclusion amount to the next calendar year.

The annual gift tax exclusion applies to gifts of any kind of property, as long as the gift is of a present, rather than a future, interest. Gifts of appreciated property also could result in income tax savings to the giver, because the recipient would pay the capital gains tax on any sale. Therefore, before giving away appreciated property that is likely to be sold, consider the income tax cost to the recipient.

A special rule allows a contributor to utilize up to five annual gift tax exclusions simultaneously when funding a 529 plan. Thus, for 2020, he or she may fund the plan with up to $75,000 (5 × $15,000), then elect on his or her gift tax return to spread this gift over five years (2020 through 2024) for gift tax purposes. By using five annual exclusions, the entire gift becomes gift-tax-free. However, the contributor must wait until 2025 to make another tax-free contribution to this plan, or any annual exclusion gifts to that child or grandchild.

Trust Tax Rates.

See below for the current tax rates versus the tax rates for 2020.

2019 Trust Tax Table

If taxable income is: Then income tax equals:

Not over $2,600                                  10% of the taxable income

Over $2,600 but not over $9,300        $260 plus 24% of the excess over $2,600

Over $9,300 but not over $12,750      $1,868 plus 35% of the excess over $9,300

Over $12,750                                      $3,075.50 plus 37% of the excess over $12,750

2020 Trust Tax Table

If taxable income is: Then income tax equals:

Not over $2,600                                  10% of the taxable income

Over $2,600 but not over $9,450        $260 plus 24% of the excess over $2,600

Over $9,450 but not over $12,950      $1,904 plus 35% of the excess over $9,450

Over $12,950                                      $3,129 plus 37% of the excess over $12,950

Capital Gains.

The adjusted net capital gain of an estate or trust is taxed at the same rates that apply to individual taxpayers.

  • A 0% rate applies to adjusted net capital gain that, if it were ordinary income, would be subject to the 10% income tax rate;
  • A 15% rate applies to adjusted net capital gain that, if it were ordinary income, would be subject to the 24% or 35% income tax rate;
  • A 20% rate applies to adjusted net capital gain that, if it were ordinary income, would be subject to the 37% income tax rate;

Investment Income Surtax.

For tax years beginning after 2012, a 3.8% surtax applies to the lesser of (1) undistributed net investment income (NII) or (2) any excess of adjusted gross income over $12,500. Any given item of NII is included in the NII of either the trust/estate or its beneficiary. Distributed NII is NII to the beneficiary as indicated on Schedules K-1, and undistributed NII is NII to the estate or trust.

Methods to Reduce Surtax Liability.

The 3.8% surtax applies to income from a passive investment activity. To help reduce the amount of income subject to the surtax the following should be considered:

  • For complex trusts, compare the tax with and without distributions to beneficiaries to determine whether the trust or individual is in the lower tax bracket
  • Use Installment Method to spread out gain on sale over multiple years
  • Use like-kind exchanges to defer gains
  • Recognizes losses to offset gains

Income/Deductions.

Some strategies that can be used to accelerate or defer income and/or deductions are looking at the:

  • Timing surrounding payment of state income taxes and property taxes, keeping in mind the new law limits the aggregate deduction for state and local taxes, including income taxes and property taxes, to $10,000 per year. Property taxes related to the production of income and investment holdings do not fall under this limitation and can be deducted in full.
  • Timing surrounding payment of other trust expenses (i.e. fiduciary, accounting, legal)
  • Revisiting the trust’s distribution strategy to see if more income can be passed out to beneficiaries taxed at a lower rate than the trust

Certain Payments of Estimated Tax Treated as Paid by Beneficiary.

The fiduciary (or executor, for the final year of the estate) may elect to have any portion of its estimated tax payments treated as made by a beneficiary (and not as payments made by the estate or trust). Such an amount is treated as a payment by the beneficiary on their Form 1040 on the January 15th following the end of the tax year. The fiduciary must make the election on the Form 1041-T, Allocation of Estimated Tax Payments to Beneficiaries. The election must be filed on or before the 65th day after the close of the estate’s or trust’s tax year.

65-Day Rule.

 Complex trust and estate distributions made within the first 65 days of 2020 may electively be treated as paid and deductible in 2019. The election is to be made on the 2019 tax return.

Trust Agreements

It is important to read the trust agreement when doing planning for trusts to see what the agreement says about income/principal distributions as well as life events. Some trusts specify that distributions should start when the beneficiary attains a certain age or a certain event occurs. If this is the case, it could have an effect on planning for the trust.

Tax planning for trusts and estates can be very complex. Please feel free to contact us with any questions you have at 858-558-9200.

Beware of the Interest-Free Loan

By Estates & Trusts

Did you know that interest-free loans of money to your friends and family can be considered a taxable gift for federal gift tax purposes? This article will help you understand the circumstances under which such gift treatment might occur.

In 1984, the U.S. Supreme Court determined that the interest-free use of money constitutes a gift for federal gift tax purposes. Thereafter, Congress enacted a tax provision which reaffirms this concept. When a person makes an interest-free term loan to a family member, the foregone interest is treated as an amount transferred from the lender to the borrower as a gift. The value of that gift is the difference between the amount loaned and the value of a loan for the loan period, and is computed using the applicable current interest rate.

For example, an interest-free loan of $100,000 for a three-year period may be treated for tax purposes as a $90,000 loan and a $10,000 immediate taxable gift. In this scenario, the $10,000 is assumed to be the calculated interest on a three-year, $90,000 loan.  Of course, the actual interest amount is dependent on the specific features of your loan, including the loan amount, the term and the market interest rate at the time the loan is made. For income tax purposes, this $10,000 calculated interest amount is then treated as transferred by the borrower to the lender as interest paid over the loan period. This second segment of the deemed transaction will generate interest income to the lender. It may produce an interest expense deduction to the borrower, but the deductibility is dependent upon the use of the borrowed funds. For example, if the borrower uses the funds to start a business, the interest may be deducted as a business expense.

If the loan is considered a demand loan, a loan that can be called for complete repayment at any time, the term of the loan is unknown.  Therefore, the interest income cannot be calculated over the life of the loan.  For demand loans, the gift value is deemed transferred for each tax year during which the repayment demand is not made. The income tax effect is the same as a term loan: the lender will have annual taxable income, and the borrower may have a tax deduction. In either of these scenarios, the gift and income tax impact cannot be avoided by signing an interest-bearing loan and then forgiving the interest annually.

Since the borrower has the current enjoyment of the funds, the imputed interest may be offset on your gift tax return by the annual gift tax exclusion ($15,000 for 2019). If you and your spouse are willing to split gifts, or if the loan was made from joint or community property funds, that exclusion amount is doubled.

The applicable interest rate used for this purpose is called the Applicable Federal Rate (AFR). Interest rate tables are published each month by the Internal Revenue Service. The tables list the minimum interest rate that may be used for personal loans.  These rates change monthly and different rates are provided depending on the length of the loan.

There is an exception when interest-free loans between individuals do not constitute a taxable gift.  When the amount of the loan does not exceed $10,000 no taxable gift or deemed interest income and expense is created. This exception does not apply, however, when the interest-free loan is for the purchase or carrying of income-producing assets.

Further, for one or more interest-free loans directly between individuals of $100,000 or less, the amount of interest income and expense treated as retransferred by the borrower to the lender at the close of any year may not be exceed the borrower’s net investment income for that year. However, this limitation does not apply where one of the principal purposes of the loan arrangement is the avoidance of federal tax.

Taxes due on interest-free loans are complicated, but the real objective of these tax provisions is to reduce the family loan transaction to its true economic components. The idea is to measure what would have been the results if the parties had dealt with each other on an arm’s-length basis. Ultimately, for federal gift tax purposes, the donor is treated as making a gift of the value of the use of the money. If the loan is a term loan, the entire value of the loan is an immediate gift.

If you have outstanding loans that are subject to these provisions, we may want to discuss filing gift tax returns to report the deemed gift or charging an interest rate to those loans. Please contact us if you require further clarification on the gift tax consequences on interest-free family loans.

Is Cash the Best Gift?

By Estates & Trusts

Are you considering making gifts to loved ones or charities? Before you pull out cash to make a gift, consider gifting other assets such as stock and real estate or holding onto those assets and bequeathing them through your estate.

There are many options for gifting assets to either loved ones or charities. However, drastically different tax consequences for both the donor and the donee can arise depending on the timing of the gift and the type of gift.

Gifting Cash

The simplest and most common gift is cash. There is an annual gift tax exclusion of $15,000 per recipient in 2019 ($30,000 for married couples). If your total gifts for the year to one individual exceeds the annual exclusion amount, then a gift tax return must be filed with the IRS. Chances are, even if you need to file a gift return, you will likely not have to pay tax on the gift. In 2019, an individual can gift up to $11.4 million during their lifetime before being subject to gift tax – effectively $22.8 million for married couples.

Gifting Other Assets

If you gift appreciated assets to another person while you are alive, the amount of the gift is considered to be the fair market value of the asset at the date that you gift it. However, your tax basis in the asset carries over to the donee. Meaning, if the recipient sells the asset immediately, they will have the same taxable gain as the donor. If the asset has a high potential for appreciation, the benefit is that the donor has effectively removed the highly appreciated asset from their estate and, thus, not subject that asset to estate tax.

However, if you gift assets that have decreased in value since you acquired them, then the recipient’s basis will be the fair market value on the date they receive it. This means they will be unable to take a loss if they sell the asset upon receipt. Therefore, when gifting a depreciated asset, it is more beneficial to sell it, receive the taxable loss at the donor level, and gift the cash.

Gifting to Charities

A gift to a charity allows the donor to receive a charitable income tax deduction in the year of the donation. The amount of the deduction depends on what you give and what type of charitable organization receives it. If donating non-cash assets to a public charity, you can take a deduction for the contribution of up to 30% of your adjusted gross income (AGI) for that year. If donating non-cash assets to a private foundation, the limit is 20% of your AGI. Any deduction that you cannot use in the year of the donation because of an AGI limitation will carry forward for the next five years. Different AGI limitations exist for cash donations.

Donating highly appreciated assets to a charitable organization may be beneficial because the donor can generally take an income tax deduction for the fair market value of the asset on the gift date and, additionally, the donor will not need to recognize a large capital gain upon disposition.

Gifting as Part of Your Estate

Upon your death, all assets in your estate will receive a “step-up” in basis.  This means that the cost basis of all assets for income tax purposes is equal to the fair market value on your date of death. Therefore, if your heirs were to sell the asset immediately when they receive it, they will pay no income tax on the sale. If the value of your estate is under the estate tax exemption amount in the year of your death, bequeathing your assets to your heirs at your death may be a great planning tool to minimizing the overall tax burden.

You can also leave assets to charities when you die. Your estate will receive an estate tax deduction for the fair market value of those assets.  However, if the value of your estate is less than the lifetime exemption amount, no estate tax will be paid regardless.  Therefore, no estate tax benefit is realized by making this gift through your estate.  In this case, it is more advantageous to gift assets to charity during your lifetime so that you can receive the income tax benefit.

With all of these factors to consider, the gifting process can sometimes be more complicated than it appears. If you have questions on consequences that could arise from a gift you are contemplating, please do not hesitate to contact our office at (858) 558-9200.

Estate Taxes Hurt! Think About a QPRT!

By Estates & Trusts

Living in beautiful San Diego, it should not come as a surprise that there are homes in neighborhoods like Del Mar and Rancho Santa Fe that are valued anywhere from $1 million to upwards of $20 million. If you own a gorgeous residence by the beach with that perfect ocean view, you should consider using qualified personal residence trusts to reduce your taxable estate. It is never too early to plan for the future, especially when the 40% estate tax is looming.

In a nutshell, a qualified personal residence trust (QPRT) is a tool that allows you to remove the value of your primary or secondary (vacation) home, and all future appreciation, from your taxable estate by making a gift that is only a fraction of the home’s value. You create the trust for a term of years and designate beneficiaries, which would be you/your spouse for this initial term and then someone else thereafter. After the term of the trust expires, the residence is then gifted to the trust. By placing your home in this type of irrevocable trust, you and your spouse can continue to live in your primary residence rent-free while maintaining the ability take all the applicable income tax deductions during the initial term (i.e. property taxes, home mortgage interest, etc.).

It should be noted that for the QPRT strategy to be effective for estate tax purposes, you/your spouse must outlive the initial term of the trust. However, if one spouse dies before the end of the trust term, the residence is once again includable in his/her estate. This would have happened from the get go and so you break even. There is little risk associated with this estate planning technique.

At the end of the trust’s initial term, you lose your interest in the trust (i.e. your personal residence). However, you can stay on as the trustee and continue to live in the home by paying rent at a fair market price. This rent income to the trust can be used to pay the costs of keeping up the home. This strategy does however allow you to give more to your heirs free of gift tax consequences.

Let us look at an example to illustrate the benefits of creating a qualified personal residence trust. Let’s say you and your spouse both create QPRTs and place 50% of the home valued at $1,000,000 in each, $500,000. You are both 55 years old and set the trust to have an initial term of 20 years. Let’s also assume you both live to age 80 and the house appreciates at 5% annually.

Example You Your Spouse Total
Current FMV  $500,000  $500,000  $1,000,000
Less Minority Interest Discount ($100,000) ($100,000) ($200,000)
Value of Property placed into QPRT  $400,000  $400,000  $800,000
Immediate Gift to Heir (3% Interest Rate)  $156,761  $156,761  $313,522
FMV of Home 20 Years Later  $1,693,177 $1,693,177  $3,386,354

Even though we cannot predict what gift and estate taxes will look like 20 years from now, it is clear that incurring a $313,522 taxable gift is likely to reduce a taxable estate by $3,386,354.

One thing to keep in mind, however, is that if the beneficiaries decide to sell the residence after the end of the term of the trust, they may incur a significant income tax liability. The property does not receive a step up in basis after the grantor passes away the way it would if the property were not placed in a QPRT. Thus, it is important to consider not only the estate tax benefits, but the income tax consequences of losing the basis step-up as well.

QPRTs may work out great in some situations, but are definitely not for everyone. There are other negative consequences that may arise when entering into a QPRT, so it is important to understand how they may or may not fit into your estate plan. If you have any questions or are interested in understanding how qualified personal residence trusts may benefit your particular situation, please do not hesitate to contact us at (858) 558-9200.

Using Trusts to Accomplish Your Charitable Giving Goals

By Estates & Trusts

With the increase to the standard deduction under the Tax Cuts and Jobs Act, it is more important than ever to carefully plan out your charitable giving to maximize the deduction on your tax return. Charitable trusts provide a way to bunch donations to a charity into one year while still allowing the donated assets to generate an income stream.

With a charitable trust, a donor can contribute assets into the trust and can determine the timing of charitable contributions. In exchange for putting their assets into a charitable trust, the donor receives a charitable deduction in the year or years that the trust is funded based upon how much of the trust’s assets will eventually go to charity.

There are two main types of charitable trusts: remainder trusts and lead trusts. With remainder trusts, a non-charitable beneficiary (usually the donor) receives an annual distribution from the trust for a specified time period and the remainder is distributed to the designated charitable organization. The non-charitable beneficiary is taxed on the income distributed to them each year. On the other hand, charitable lead trusts are just the opposite – the charity receives the annual distributions from the trust and the amount remaining at the end of the trust’s life goes to the designated non-charitable beneficiary (usually the donor’s family member). Within charitable remainder and lead trusts, there are different ways to determine how much will be distributed from the trusts each year. Unitrusts pay out a fixed percentage of the fair market value of the assets each year, determined on a specific date, whereas annuity trusts pay out a fixed dollar amount each year, regardless of how well or poorly the assets perform.

There are several benefits of setting up a charitable trust, but there are also some disadvantages to consider. These include:

Benefits:

  1. Charitable deduction – Donors receive a charitable deduction on their individual income tax returns for contributing assets to the trust.
  2. Avoiding capital gains tax – If a donor has highly appreciated assets, selling the assets outside of a charitable trust can generate an enormous tax liability to the donor. When assets are sold inside a charitable trust, the gain from the sale is not taxable. Taxable income is only based on the amount of distributions made to the donor or other non-charitable beneficiary.
  3. Diversification – Because capital gains tax can be deferred or avoided by selling appreciated assets inside a charitable trust, this gives donors an opportunity to diversify their assets without losing a chunk of their principal to taxes.
  4. Excluded from the donor’s estate – Assets in a charitable trust are excluded from the donor’s estate and are, therefore, exempt from any estate taxes.

Limitations:

  1. Irrevocable – Once the trust is set up and funded, the donor cannot terminate the trust or remove contributed assets from the trust.
  2. Costs – An attorney is needed to set up a charitable trust and an accountant is likely needed to file annual tax returns. This means there are ongoing costs associated with maintaining a charitable trust.
  3. Risk of poor performance – Like any other asset, the assets in the trust may decline in value or produce less income than expected. If the beneficiary of the trust is depending on the income distributions, this can risk putting them in a poor financial position.
  4. Asset limitations – Not all assets can be put into a charitable trust: for example, shares in an S corporation cannot be held by a charitable trust.

Charitable trusts can be wonderful and flexible ways to give to your favorite charity, while still maintaining some control over your assets. However, charitable trusts can be complex and confusing, so please contact us if you would like to discuss whether it makes sense for you.

2019 Estate and Gift Planning Update

By Estates & Trusts

Tax reform made to sweeping changes to the tax code.  The notable change to gift and estate tax is the doubling of the lifetime gift tax exemption from $5 million to $10 million, adjusted for inflation.  This increased lifetime exemption opens the door for enormous estate planning opportunities.  However, this change is only temporary. Click the link below to learn more.

When considering gift and estate taxes, there are two important concepts every taxpayer should be aware of: the lifetime estate and gift tax exemption and the annual gift tax exclusion.

  • The lifetime exemption is the total amount of taxable transfers a US citizen can make during lifetime and at death without incurring any gift or estate tax. Any transfers made in excess of the lifetime exemption are subject to estate tax.
  • The annual exclusion is the amount that one person may transfer to another each year as a gift without being treated as taxable. Any gifts made in excess of the annual exclusion are considered taxable gifts and count against the donor’s lifetime exemption.

Use of Applicable Exemption Amount to Reduce Estate and Gift Tax

As a result of the Tax Cuts and Jobs Act, the lifetime estate and gift tax exemption has doubled. In 2019, that amount is inflation adjusted to $11,400,000.  The increased exclusion is only available for individuals who die or for gifts that are made after 2017 and before 2026.  In 2027, this exemption is set to revert back to the original $5 million base amount.  The temporary increase presents enormous estate tax planning opportunities for both individuals and couples.

Once an individual’s lifetime gifts or estate exceeds the exemption threshold, all additional taxable gifts or estate value are taxed at the 40% rate.  Therefore, any planning that reduces the value of an estate subject to this tax can create large savings.  There are two main strategies for taking advantage of the exemption increase; keep in mind that these strategies are often beneficial even without the temporary changes.

The first strategy is to take advantage of the portability election.  Portability is an election filed on an estate tax return that allows the transfer of any unused exemption from a deceased spouse to a surviving spouse.  This concept becomes especially important for married couples who have an estate that is not taxable under current law, but may be taxable after the temporary exemption increase is over.

The second strategy is to make gifts to individuals or irrevocable trusts up to the maximum lifetime exemption under current law.  By making the gifts now, the gifted assets are removed from your estate.  Therefore, even after the exemption is reduced back to original levels, these assets will not be subject to estate tax upon your death.  It is important to keep in mind that if an asset is given during lifetime, the donee takes the donor’s tax basis (cost). If an asset is acquired from an estate at death, the basis is the value of the asset at the date of death. Therefore, it is important to understand the additional tax consequences and consider asset selection when making gifts during your lifetime.

It is also important to note that the generation-skipping transfer (GST) tax exemption for transfers that are deemed to “skip” a generation, such as gifts to your grandchildren or anyone 37.5 years younger than you, has also doubled and inflation-adjusted to $11,400,000.  Like the estate and gift tax exclusion amount, the increased GST exemption amount is only available for transfers made after 2017 and before 2026. However, unused GST exemption does not qualify for portability.  Like the estate and gift tax rates, the rate used for calculating the GST tax is 40%. The GST tax applies in addition to the gift or estate tax.

 Annual Gift Tax Exclusion

The most common method for tax-free giving is the annual gift tax exclusion.  In 2019, this amount is $15,000.  Any individual can directly gift $15,000 to any person without reducing their lifetime gift tax exemption amount.  Because the annual exclusion is applied on a per-donee basis, a person can leverage the exclusion by making gifts to multiple donees (family and non-family). Thus, if an individual makes $15,000 gifts to 10 donees, he or she may exclude $150,000 from their estate. In addition, married couples may effectively double the amount of the exclusion to $30,000 per recipient.

The annual gift tax exclusion applies to gifts of any kind of property, as long as the gift is of a present, rather than a future, interest. Gifts of appreciated property also could result in income tax savings to the donor, because the recipient would pay the capital gains tax on any sale. Therefore, before giving away appreciated property that is likely to be sold, consider the income tax cost to the recipient.

The increased estate and gift tax exclusion amount for 2019 gives individuals even more opportunities to transfer assets to their desired loved ones without incurring estate and gift taxes. If you wish to take advantage of the planning techniques that are described above, please feel free to contact us at 858-558-9200.

Overlooking Portability Could Cost You

By Estates & Trusts

Do not let the word portability scare you.  It is simply the act of transferring a decedent’s unused gift and estate tax exemption to the surviving spouse.  Since the exemption has doubled under the Tax Cuts and Jobs Act, married couples now have the potential to save millions of dollars in estate tax.

The recently enacted Tax Cuts and Jobs Act included a provision that doubles the federal estate and gift tax exemption; increasing it from $5 million to $10 million, indexed for inflation.  In 2019, this exemption amount is $11.4 million.  However, this change is only temporary and is due to sunset in 2026, returning the exemption back to $5 million (indexed for inflation), unless Congress intervenes.

Thus, in 2019, estates that are worth up to $11.4 million are not subject to tax.  If married, both spouses are allowed this exemption.  So, what happens if your spouse passes away and their portion of the estate is less than $11.4 million?  If nothing is done, the remaining unused exemption is lost.  If, however, an estate tax return is filed timely and the portability election is made, the remaining exemption can be transferred to the surviving spouse to increase the surviving spouse’s available exemption when he/she dies.

Very few couples have estates larger than $22.8 million.  According to the Tax Policy Center, less than 0.1% of individuals, or about 1,700 people who pass away in 2018, will be required to file an estate tax return.  Therefore, many married couples will disregard the thought of filing a return.  However, filing a return to elect portability has the potential to save millions in estate taxes for the surviving spouse.

Example: Bob and Clara are married and reside in California. Bob passes away in January of 2019 when their estate consisted of $16.8 million of community property. An estate tax return is not required. However, Clara must choose whether or not to file a timely estate tax return to elect portability.

  • Scenario 1 – File a return and elect portability: Since Bob died in 2019, his lifetime exemption is $11.4 million. His gross estate is $8.4 million (50% of $16.8 million). He has $3 million of unused exemption that can then be ported to Clara. If Clara dies after the tax reform bill sunsets in 2026 or later, her lifetime exemption is scheduled to be reduced to the original level of $5.7 million plus $3 million ported to her from Bob’s estate. Her new exemption will be $8.7 million.  If Clara dies in 2026 and the her estate is still valued at $8.4 million, her estate will pay no tax.
  • Scenario 2 – No return is filed: If no estate return is filed, Bob’s unused exemption is lost. If Clara dies in 2026 with an estate worth $8.4 million and the lifetime exemption drops to $5.7 million, her estate will have to pay tax on about $2.7 million. That is over $1 million of tax that could have been avoided.

As you can see from the example above, filing a return to electing portability has enormous tax savings potential if the lifetime exclusion is reduced in the future.  It is also beneficial when the surviving spouse expects the value of the estate to grow over time and surpass the exemption amount. Without knowing what the future holds, electing portability can be seen as an insurance policy in case the unforeseeable happens.

In conclusion, portability is the ability to preserve the unused portion of the deceased spouse’s estate tax exemption.  Now, more than ever, portability is a relevant planning tool that allows married couples to take advantage of the increased exemption.  It is also important to note that that any amount carried over to the surviving spouse is lost if they remarry.  If you have questions regarding portability, estate tax planning, or any tax matters, please feel free to contact your L&B professional at (858) 558-9200.

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