California Estate Planning Taxes

Our clients often ask us about estate taxes. They want to know how they can set up their living trust estate plan to avoid estate taxes. That leads to a discussion about the four different taxes related to estate planning. These taxes include Estate Tax, Gift Tax, Capital Gains Tax and Property Tax.

Estate Tax

The 2023 federal estate tax exemption is $12,920,000 per person. This means that you will not be subject to an estate tax unless your estate is valued at more than $12,920,000. Married couples can double this amount. Unless your estate is close to $13M, or as a married couple, close to $26M, then you won't have an estate tax.

However, this is subject to change. If Congress and the President do not change the law, then in 2026, the estate tax exemption will drop to $6M - $7M. For more details on the estate tax, click here.

In addition to the federal estate tax, many states have a separate state estate tax. Believe it or not, California (so far 🙏) does not have a state estate tax. At least we have that going for us.

Gift Tax

The gift tax is related to the estate tax. In fact, the full name of the estate tax exemption is the "estate and gift tax exemption."

The estate and gift tax exemption (currently $12,920,000) is the amount you can gift and die with before there will be a tax. Gifts you make during your lifetime are deducted from the estate tax exemption. For example:

• If you gift $1,000,000 during your lifetime, your remaining estate tax exemption will be $12,920,000 - $1,000,000 = $11,920,000.
  
  
• If you gift $5,000,000 during your lifetime, your remaining estate tax exemption will be $12,920,000 - $5,000,000 = $7,920,000.
  
  
• If you gift $10,000,000 during your lifetime, your remaining estate tax exemption will be $12,920,000 - $10,000,000 = $2,920,000.

Any gifts you make during your lifetime are deducted from your estate tax exemption, and whatever is left is the amount you can die with to avoid an estate tax.

As long as your lifetime gifts are less than the exemption, there won't be a gift tax. And as long as your estate is less than your remaining exemption, there won't be an estate tax.

But wait, there's more on the gift tax. As explained above, lifetime gifts must be deducted from the estate tax exemption. However, federal tax law includes an "annual gift exemption." The annual gift exemption, which his currently $17,000, is different from the estate and gift tax exemption. The annual gift exemption is a freebie. You can use it, and it won't be deducted from the estate tax exemption.

Each year, you can gift $17,000 per person to anyone. If you are married, your spouse can also gift $17,000 per person to anyone. As a couple, you can gift $34,000 per person to anyone. The benefit of the annual gift exclusion is that it doesn't affect the estate and gift tax exemption. If you gift $34,000 to ten people for a gift value of $340,000, your estate and gift tax exemption will still be $12,920,000. 

The annual gift tax exemption was a big deal back in the olden times of the 1990s when the estate and gift tax exemption was only $600,000. Now that the estate and gift tax exemption is so big (almost $13M), leveraging the annual gift tax exemption is not that important for most people. For more on the recent history of the estate and gift tax, click here.

Capital Gains Tax

Another tax related to estate planning is the capital gains tax. When you sell an asset, there is a capital gain (or loss). The capital gain is the net sale price minus the asset's tax basis. The tax basis is the purchase price of the asset plus the cost of capital improvements.

Let's use your family home as an example. If you bought your home for $500,000 and you spent $100,000 on upgrades, then your tax basis of your home is $600,000. If you sell your home for $1,100,000 and net $1,000,000, then your capital gain is $1,000,000 - $600,000 = $400,000.

Carry-Over Tax Basis from Lifetime Gift

If you gift you home to your son, your son will get your tax basis. If your tax basis for the home is $600,000, then your son's tax basis will be $600,000. This is called the "carry-over tax basis." You, as the lifetime gift maker, carry-over your tax basis to your son, the gift recipient.

If your son subsequently sells the home for $1,100,000 and nets $1,000,000, his capital gain will be $1,000,000 - $600,000 = $400,000. Since he received a carry-over tax basis, the same tax basis you had, his capital gain will be the same as yours would have been.

Step-Up Tax Basis from Inheritance

In contrast to a lifetime gift with a carry-over tax basis, is an inheritance, which has a "step-up tax basis." The step-up tax basis is the date of death value of the home. If at the time you die, the home is worth $1,100,000, then the step-up tax basis will be $1,100,000.

If after your son inherits your home, he sells it for $1,200,000 and nets $1,100,000, he will have no capital gain. $1,100,000 net profit - $1,100,000 step-up tax basis = 0 capital gain.

The difference between a carry-over tax basis and a step-up tax basis will make a big difference if the gift recipient intends to sell the home. 

California Property Tax

Us silly Californians passed Proposition 19 in 2020, and like most new laws in California, it made things much worse. For more on Proposition 19, click here.

In California, the property tax is roughly 1.2% of the assessed property value. The assessed value is generally the same as the purchase price. If you bought a home in the 1980s for $200,000, your property tax would be approximately $2,400 per year. Fast forward to 2023, your home is now worth $1,200,000. If the property tax was based on the current fair market value, the property tax would increase to $14,400 per year. Big difference between $2,400/yr and $14,400/yr.

In the days before Proposition 19, you could leave your home and even your rental properties to your children and the property tax on those properties would not change. But under Proposition 19, property transfers to your children are subject to reassessment. This means the county assessor will appraise the property as of the date of transfer and reset the property tax to 1.2% of the appraised value. 

Using the above example, before Prop 19, if you transferred your home to your children, whether by lifetime gift or by inheritance through your living trust, the property tax would remain at $2,400/yr. However, under Prop 19, when the home is transferred, it will be reassessed and the property tax will increase to $14,400/yr.

The one exception to reassessment under Prop 19 is if the transferred property is your home, and one of your children make it his or her home. In that case, the property will not be reassessed and the property tax will remain as it was.

As you can see, there are more taxes than just estate taxes to consider when you are doing your estate planning.