Estate Tax Law Changes
The federal estate tax (or the so-called “death tax”) is a tax imposed by the federal government on the value of all assets and property left by a deceased person. Under the current law, the estate tax for 2012 will apply to estates that exceed $5,000,000 per person at a 35% tax rate. Consequently, the estate tax will impact only those individuals worth more than $5,000,000, or couples worth more than a combined $10,000,000. But these figures apply only for the remainder of 2012.
If Congress and the Administration do nothing to change the current law before the end of 2012, then for 2013 the estate tax will apply to estates that exceed $1,000,000 at rates of 55%. Yes, that’s a significantly lower threshold and a much higher rate! In the event that the law does not change for 2013, then we will need to evaluate other strategies to manage the potential impact of that lower threshold and higher applicable tax rate.
An interesting feature of the estate tax law for the remainder of 2012 is the “portability” of the individual estate tax exemption between married couples. For married couples, any unused portion of a deceased spouse’s federal estate tax exemption can be claimed by the surviving spouse. What this means is that upon the death of the first spouse, any left-over portion of the deceased spouse's exemption will carry-over to the surviving spouse, so that the surviving spouse’s estate will benefit not only from their own exemption, but also the additional left-over amount of their pre-deceased spouse’s exemption.
I will keep a close eye on any developments in this regard and will keep you informed of anything that might require an adjustment to your existing estate plan.
Gift Tax Law Changes
In addition to the estate tax, the federal tax law also sets forth provisions applicable to gift tax, or the tax that must be paid by the person making a gift, if the gift exceeds a certain threshold. The gift tax has been changed for 2011 and 2012, unifying the tax rate and the lifetime exemption with the estate tax. The gift tax now has a top rate of 35% and a lifetime exemption amount of $5,000,000.
With regard to the annual gift tax exemption, that remains $13,000 per recipient per year. What that means is simple: Anyone can give up to $13,000 in gifts to any one person in any annual period without any gift tax implications. Gifts to spouses (who are U.S. citizens) and payments directly to hospitals or educational institutions are excluded from gift tax and, therefore, may exceed the $13,000 threshold without triggering any gift tax or eroding the lifetime gift tax exemption.
Capital Gains Tax Changes
In addition to the changes surrounding the estate tax and gift tax, the laws effecting capital gain on inherited property have changed for 2011. For the year 2010, the tax structure for unrealized capital gains changed to allow for a “carry-over” basis (meaning the entire long-term capital gain could be taxable to the person inheriting the asset if that person sold the asset). The law allowed for a maximum $1,300,000 exemption per estate from capital gains, and an additional $3,000,000 capital gains exemption if the assets were tarnsferred to a surviving spouse.
With the many tax law changes that took effect on January 1, 2011, the oddity with the treatment of capital gains has disappeared and the law returned to its pre-2010 normalcy -- upon the transfer at death of an asset with a capital gain, the recipient receive a "full step-up" in basis. In other words, the recipient who inherits the asset get as the cost basis the fair market value of the asset at the time of the person's death. What this means is that the entirety of any unrealized capital gain will not be subject to any capital gains taxation to the recipient if the recipient chooses to sell the inheritd asset.
COMMUNITY PROPERTY WITH RIGHTS OF SURVIVORSHIP
During 2001, California law changed to allow married couples to hold title to property in a new way that provides the advantages of both community property and joint tenancy. California law now allows married couples to hold title to assets as "community property with rights of survivorship." The advantages of this are obvious, first (just like joint tenancy) the asset avoids probate because ownership passes automatically to the survivor and second (just like community property) the survivor gets the benefit of a full step-up in basis upon the death of the first spouse. Of course, there are specific requirements for describing title to gain these advantages.
JOINT TENANCY VS. COMMUNITY PROPERTY
Most California married couples own their homes as joint tenants because they want the surviving spouse to own the entire home, without any formal court proceeding to confirm the ownership transfer. Unfortunately, holding title as joint tenants can seriously affect the taxation of any subsequent sale of the property after the death of the first spouse. This is because the United States Internal Revenue Code provides special treatment for property owned by a married couple as community property, but not for similar property owned as joint tenants.
When a person dies, his or her heirs are treated as if they purchased the deceased person's property for its fair market value on the date of death. However, if the deceased person owned only a one-half interest as a joint tenant, only that one-half interest receives this treatment (called an "adjusted basis").
To illustrate, a married couple, Edward and Mary, buy a house for $400,000 and take title as joint tenants. In such a case, the IRS considers that each paid $200,000 for their one-half interests. If Edward later dies, Mary automatically becomes owner of the entire house, and Edward's one half share of the house is re-valued as of the date of his death. If the house was worth $1,500,000 when Edward died, then Mary's adjusted basis in the house becomes $950,000 -- computed by adding her share of the purchase price ($200,000), to the value of Edward share when he died ($750,000).
In contrast, the IRS treats community property as if it were owned completely by the deceased spouse, in applying this special "adjusted basis" rule. Therefore, if Edward and Mary had owned their home as community property, and Edward later died, the entire house would be assigned a new basis at current fair market value.
The result is that if Mary decides to sell the joint tenancy house for $1,500,000 shortly after Edward's death, she would realize a taxable capital gain of $550,000 (the $1,500,000 sale price minus her $950,000 "adjusted basis," computed two paragraphs above). If the same house were owned as community property, however, she would recognize no capital gain, because her "adjusted basis" would be the same as the current market value. This amounts to sizable savings for income tax purposes.