There has been a lot of talk about taxes lately due to tax reform passed under the Donald Trump administration. Many people are under the mistaken belief that they will not owe taxes when a loved one dies due to the estate tax exemption being so high.
Here is a brief review of the recent estate tax law changes.
Under the recent amendments and changes to the Federal Estate Tax, there is a $11.18 million exemption from the Federal Estate Tax. This means that if you have less than $11.18 million in assets when you die (including life insurance), then your loved ones will not have to worry about the estate tax.
As you can see, there is a very small number of people who will be impacted by the Federal Estate Tax.
However, it is not the Federal Estate Tax that families need to worry about.
It is the Income Tax and Capital Gains Tax that families should be worried about.
As many people know, the capital gains tax applies when you have a taxable gain after selling an asset. Whether that is real estate, stocks, bonds, or other investments.
For example, if you buy 1000 shares of stock in ABC Company in 1980 for $1,000 and you later sell your 1000 shares in 2018 for $10,000, you will have a $9,000 gain. Depending upon your individual tax bracket, you will be taxed on the $9,000 gain at a top rate of 20% (or pay $1,800 in taxes).
Let’s apply this to the looming tax issue that many families are not considering. Let’s use a piece of property that nearly every family owns, their home and personal residence. Now, let me tell you a story to illustrate this point.
John and Jane bought their home together in 1980 for $70,000. They lived in the home for over 25 years and raised all three of their children in their home. In 2018, John died leaving everything he owned to his wife, Jane. At the time of his death, the home was worth $950,000. However, now, due to the size and the fact that John is now gone, Jane wants to sell the home. Will Jane owe any taxes?
When you own property that could be subject to the capital gains taxes there is a concept called step up in tax basis. Let’s use the example above.
Instead of selling the 1000 shares of stock in ABC Company, John decides to leave the stock to his son, Bill at his death. In 2018, Bill inherits the 1000 shares of stock from John after his death. Bill has a different tax basis. Bill does not have a $1,000 tax basis (the amount John paid for the stock). Bill’s tax basis is $10,000 (the value of the stock on the date of John’s death). Bill received a step-up in tax basis when he inherited the stock from John. Therefore, Bill, if he wanted to, could sell the stock for $10,000 and not owe any capital gains taxes.
However, when you are a married couple and you own property jointly, there are different rules that apply. Let’s go back and look at John and Jane’s tax issue.
Now that John was gone, Jane wanted to sell the home that they lived in together and move into something smaller. Jane lists the home for sale and sells the home for her asking price of $950,000.
What is Jane’s tax bill?
Jane’s potential tax bill is $50,000.
Well, when you own property, such as a home, as a married couple and one of the spouses dies, the surviving spouse does not receive a full step-up in tax basis to the date of death value like Bill did when he inherited his dad’s 1000 shares of stock in ABC Company.
Instead, the surviving spouse receives a ½ step up in tax basis to the date of death value.
John and Jane bought the home for $70,000, and now it is worth $950,000. Jane later sells the home after John’s death for $950,000. Jane’s tax basis for determining her tax liability is ½ of the date of death value, or $475,000. However, Jane, because it is her personal residence, is entitled to an exemption of $225,000 from the capital gains tax.
$250,000 x 20% Tax Rate = $50,000 in Capital Gains Taxes
Due to Jane’s individual tax rate, she was going to be taxed at the 20% capital gains tax rate.
However, there was a legal strategy available for John and Jane that could have eliminated the taxes and saved Jane $50,000!
It is called the Tennessee Community Property Trust Act.
This is a Tennessee law that allows you to create a Revocable Living Trust and designate that any property that you transfer into this special type of trust to be considered as community property. The benefit of turning certain types of property into community property is the tax savings.
Let’s say that John and Jane had established the John and Jane Family Community Property Trust, and then they transferred the title of their home into this trust.
At John’s death, the value of the home would receive a step-up in tax basis not equal to ½ of the date of death value ($475,000) but would receive a full step-up in tax basis to the date of death value ($950,000). This would have allowed Jane to sell the home and not incur capital gains taxes.
A savings of $50,000!
However, let’s go even further. Let’s say Jane didn’t sell the home and continued to reside in the home until her death several years later. During Jane’s lifetime, the home increased in value yet again and was worth $1,000,000 on the date of her death.
Due to John and Jane establishing the John and Jane Community Property Trust, the home received a full step-up in tax basis to $950,000 on John’s death, and then received a full step up in tax basis again to $1,000,000 on the date of Jane’s death.
When their children later sold the property after Jane’s death for $1,000,000, the children were not required to pay any capital gains taxes either!
It is this type of planning that can allow you to save your spouse a considerable amount of money in taxes (in John and Jane’s case it saved them $50,000) ¸ as well as save your children time, money, and expenses after both of you have passed away. If you have more questions about this type of planning and whether it is right for your family, please send us your question below. You can also click the link below and schedule an initial planning strategy session to determine if this type of planning is right for you.
Call your Nashville, Tennessee Estate Planning Attorney, Daniel Perry, at (615) 472-2482 and Begin the Process of Protecting Your Family and Truly Leaving a Legacy You Can Be Proud Of!