Reprinted from the June 1995 issue produced by Real Estate Today® by permission of the NATIONAL ASSOCIATION OF REALTORS®. Copyright 1995. All rights reserved.
Haste Makes Waste
By Marc S. Weissman
Failing health. Terminal illness. The feelings these words conjure are certainly unpleasant-and so is the financial decision-making process they require. But make hasty decisions, and your heirs may pay the price. To plan for a future beyond your lifetime, it's important to understand what becomes of a person's estate.
Step Up to the World of Estate Planning
People who are approaching death often decide to sell property so that their family will have cash. The deci-sion is made with good intentions, but more often than not the sale is a folly. Section 1014 of the tax code pro-vides a step-up in basis for property that's passed on. In other words, assets received as a result of death (whether through inheritance, joint tenancy, living trust, or other means) are treated for the recipient's future income tax purposes as if the recipient has bought the inherited assets at their fair market value on the date of death.
Here's an example. Bob owns XYZ stock. He bought it at $10; it's now worth $100. If he sells it before he dies, he must pay capital gains tax on the $90 profit. But if his heirs inherit the stock, the basis is stepped up to $100, so they pay tax only on the post- death profit when they sell the stock. Thus, if they sell the stock later for $125, only the $25 gain will be taxed.
Applying Section 1014 to real estate can have even more dramatic results. Lets say Bob owns a rental prop-erty worth $350,000, which cost him $125,000. Over the years Bob has claimed $75,000 of depreciation, leaving him with a $50,000 basis. If Bob sells the property before he dies, he'll owe tax on the $300,000 profit ($350,000 minus the $50,000 basis). If instead, Bob passes the property on the heirs, the property will be treated as if his heirs had bought it for $350,000. The heirs can either sell it and pay no tax on the predeath profit or hold it as a rental property and start depreciat-ing it again with a $350,000 basis.
This step-up basis rule applies to most investments; the only exceptions are retirement plans or assets cre-ated by the deceased person, such as artwork.
Is a Sale Ever Warranted? Rarely.
Deathbed sales make sense only if property has a built-in loss. If Bob bought IBM stock at $110, and Mary inherits at a $50, Mary's basis is $50 (the fair mar-ket value on the date of Bob's death). But if Bob sells the stock before his death, he can deduct the loss on his final tax return and leave Mary the cash.
Another reason to sell an asset might be to take advantage of a tax shelter. For example, Bob may be able to sell his primary residence and claim the over-55 rule on his final tax return. That rule allows him to ex-clude up to $125,000 in profit, something his heirs might not qualify for. But there's a disadvantage, too-- the loss of step-up basis. If his heirs inherit the property and then sell the property right away, they'll have no capital gain, anyway, since their basis is the value at the date of death.
What if Bob's heir is his spouse? If Bob and Mary are married and own the XYZ stock in joint tenancy, it means Mary already owns half. So when Bob dies, she inherits the other half and receives a step- up basis for only the inherited stock. In the earlier example, in which the stock went from $10 to $100, her tax basis would have been $55, $5 for the half she already owned and $50 for the half she inherited at the step-up value.
Seven state have community property laws. If Bob lives in one of those states, he and Mary could hold their assets as community property. After Bob's death, both halves would be stepped-up -- a major benefit of community property. Despite what you may have experienced in a divorce court, for a property to be favorably treated as community property, it must be desig-nated as such in writing. Unmarried couples who live together often own property, as tenants in com-mon. In that case, if one of the parties dies and the other inherits that person's share, the survivor gets only a half step-up in basis.
The Problem with Probate (and How to Avoid it)
Probate is the state's method of making sure the proper beneficiaries get what they're entitled to. Although state laws vary, here's the typical procedure. The will is filed. Then, assuming nobody contests the will, the list of assets is filed with the court, and creditors get notice. Several months later, the judge blesses the will, and the beneficiaries receive their inheritance. If there's no will, the estate is said to be intestate, in which case the judge, using state law as a guide, decides the beneficiaries, generally the surviving spouse and children.
Probate is time-consuming and can be expensive, with some states charging a percentage of the estate's asset value. If you want to avoid probate, you can do one of two things: Set up a living trust or convert property to joint tenancy.
A living trust is a substitute for a will. Think of it as being like a corporation; when the owner or president of the corporation dies, the corporation stays alive. Similarly, when the founder of the trust dies, a new manager (trustee) is appointed, and the trust stays alive. Since the trust--not you--owns your estate, there's no need for your assets to go into probate. A living trust won't protect your assets from creditors. But after your death, as long as your assets remain in the trust, they're protected from your heirs' creditors.
A living trust is flexible. During your lifetime, you can spend the money in it, give it away, or burn it. You can even revoke the trust and disinherit your heirs. As founder of the trust, you name successor trustees-as many as you'd like. And you structure what goes to your heirs and when.
Real estate can be part of your living trust. For example, you can build a house and live in it, and it can be owned by the trust. If you sell the house, the trust owes the tax on any profit. In your lifetime, though, you file no special tax returns for the trust--the trust's tax-able income is reported on your individual return. After your death, the trustee files a return for the trust.
A living trust will most likely set you back $1,500-$3,000 in attorneys' fees. You could get one for less; just make sure you don't sacrifice thoroughness for savings. Use an attorney who's well versed in estate planning.
Another Solution That Offers Its Own Troubles
Another Solution That Offers Its Own Troubles
Converting your real property to joint tenancy is another way around probate. After you die, your property instantly goes to the joint tenants. However, if your estate is substantial, you may be letting your heirs in for some extra taxes. They'll have to pay estate tax on any amount over $600,000. With a living trust, however, since the assets aren't actu-ally passed directly to your heirs, there's no estate tax regardless of the value of assets in the trust.
For tax purposes, between any partners but spouses, property held in joint tenancy is treated as being fully owned by the decedent--that's legalese for the one who died. For example, to avoid probate, Clara puts her house into joint tenancy with her son, Jack. When Clara dies, the house is treated as all Mom's; consequently, Jack receives a full step-up in basis.
In some cases a joint tenant may not want to receive the full step-up basis. Let's say Clara'shouse is worth $800,000. that means Jack will owe estate tax on his inheritance. If Jack actually contributed to the home's purchase -- bringing his inherited share to less than $600,000 in value--he may be able to escape the tax.
Joint tenancy may sound like a simple, ideal solution, but real life sometimes intervenes to make it a less- than-perfect option. Let's say Clara has made Jack a joint tenant, and she's still alive. Jack gets in a car acci-dent and is sued. The victim may end up owning Jack's half of the house. If Jack gets divorced, his wife may claim part of Clara's house-or Jack may even give away half of his mom's house.
Its clear that hurried decisions brought on by an illness or pending death are often a mistake. But hasty missteps are avoidable. With a little planning--and the help of an estate tax expert--you can put yourself and your heirs on the right path.
One way to avoid the estate tax is to give assets away. You can give each of your family members and friends a gift of up to $10,000 a year tax-free. If possible, the gifts should be of high-basis assets to minimize the effect of losing the step-up basis. For example, Mary has assets worth $700,000. If she gives each of ten family members a $10,000 check, and the checks are cashed before her death her estate is reduced to $600,000 in value, so her estate tax drops from $37,000 to zero. To help a surviving spouse avoid estate tax, you can set aside up to $600,000 in assets in a bypass trust. Rather than taking your estate and saying, "It's all yours, honey," you can set up a bypass trust, which allows you to say, "It's not yours, but you can spend it."
A bypass trust can be created in a will or through a living trust, but the living trust is generally the best choice: You'll avoid unnecessarily complicating your will, and your beneficiary will avoid probate.
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