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Estate Tax Not An Issue Anymore – It’s About Income Tax

I spent the last four days in San Diego (I know, tough assignment) at the annual Southern California Tax and Estate Planning Forum – a gathering of about 400 attorneys learning from the top estate planning experts in the country. The main topic this year was how the American Taxpayer Relief Act, which became law on January 1, 2013, has completely changed the focus of estate planning.

We Used to Focus on Estate Tax

Since I starting doing estate planning in 1996, estate planners had always focused on reducing or eliminating estate tax. Now the focus needs to shift to reducing capital gain and income tax.

Under the new law, the unified exemption is now $5,250,000, indexed for inflation. This means every U.S. person can own up to $5,250,000 at the time they die, with no estate tax. The estate tax rate, which is now 40%, only kicks in if your estate exceeds that amount. And if you are married, you get two exemptions for a total of $10,500,000.

How does this big exemption change the focus of estate planning? Well, for most people (99% of the population), estate tax will no longer be an issue. Most estate are way below $5 million and certainly way below $10 million for married couples. Contrast this to 1996, when the exclusion amount was $600,000.

You may be familiar with the terms A/B trust, bypass trust, credit shelter trust or exemption trust. These all refer to the fundamental planning strategy of setting aside the deceased spouse’s share of the estate into an estate tax exempt irrevocable trust (a bypass trust), so when the surviving spouse dies, only her half of the estate would remain subject to the estate tax.

How the Bypass Trust Works

Here is an example of how a bypass trust eliminates estate tax.

It’s 1996. Husband and wife had an estate worth $800,000 and the exemption amount was $600,000. Husband died first. His share of the estate ($400,000) was transferred to a bypass trust to use his exemption amount. Because his share of the estate ($400,000) was less than the exemption amount ($600,000), there was no estate tax.

When wife died five years later, her share ($400,000) was also less than the exemption amount, so there was no estate tax on her death.

Notice what happened. If husband had gifted his half of the estate to wife, and he did not use a bypass trust, wife’s estate would be $800,000, which is greater than her $600,000 exemption amount. This would have caused an estate tax on the difference ($200,000). The estate tax would have been $110,000 ($200,000 by the then estate tax rate 55%). By using the bypass trust, the family captured two exclusion amounts (husband’s and wife’s) and saved $110,000. That’s a lot of money and well worth the planning.

Using a bypass trust is a great way to eliminate estate tax. However now that the exemption amount is above $5 million, it may not be necessary, and may create a problem with capital gains and income tax.

Tax Basis, Step-Up in Basis and Capital Gains

For this to make sense, you need to understand tax basis and the capital gains tax.

Let’s say husband and wife buy a rental property for $100,000. Their tax basis in the property is the purchase price. In ten years they sell it for $500,000. Their capital gain is the difference between the sale price and their tax basis ($500,000 – $100,000 = $400,000). They will have to pay a tax on the $400,000 gain.

The tax code allows a “step-up” basis on inherited property.

Husband dies when the property is worth $500,000. Wife’s new tax basis in the property is the date of death value, $500,000. If she then sells the property for $500,000, her capital gain is zero ($500,000 sale price – $500,000 basis = $0 capital gain). For capital gains tax purposes, it is way better to sell after you inherit a property.

Because California is a community property state, when one spouse dies, the property receives a 100% step-up in basis. Even though husband owned only 50% of the property, on his death, wife receives a step-up basis in 100% of the property.

By selling after her husband died, wife paid no capital gains tax. Now watch what happens when wife dies.

Wife lives another ten years. When she dies the property is worth $800,000. The kids inherit the property and receive a step up in basis. If they sell the property for $800,000, there is no capital gain tax ($800,000 sale price – $800,000 basis = $0 capital gain.)

The property got two step ups in basis – when husband died and when wife died. As a result, the family saved a lot in capital gains tax.

Now you understand capital gains tax and the step up in basis for inherited property rule. Which brings us back to the bypass trust.

Why You May Not Want a Bypass Trust Anymore

The problem with transferring the property to a bypass trust is that the property will only receive one step-up in basis. 

Let’s go back to the original example. Husband dies. On husband’s death, the property received a step-up basis to $300,000. To eliminate the estate tax, the property is transferred to a bypass trust. Although wife is the trustee and beneficiary of the bypass trust, she is not the owner of the property. The owner is the bypass trust.

When wife dies, the property does not receive a second step-up in basis. The tax code does not allow a step-up in basis to a bypass trust. So although the bypass trust was great for eliminating the estate tax, it did not help in eliminating the capital gains tax.

Why is this significant? Now that the exclusion amount is over $5 million, there is no reason to use a bypass trust to avoid estate taxes. If a bypass trust is used, the children will have to pay capital gains taxes when they sell the property they inherit. Under the new law, for most people, it will be better not to use a bypass trust and preserve the second step-up in basis.

This is especially true in California. The federal capital gains tax is now 20% and the California income tax is 9.3%.

Review Your Estate Plan

Now may be a good time to review your estate planning documents. You may want to double check the funding provision in your living trust. If it requires the creation of a bypass trust you may want to amend your trust.

As one of the speakers at the event this week said, estate planners have been planning the same way for decades – to avoid the estate tax. The new law has turned the tables, and now the focus needs to be on capital gains and income tax planning.


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