February 10, 2007

Traditional Estate Tax Planning Will Now Have to Include Sophisticated Income Tax Planning

Houston Tax Attorney Blog

Houston Tax Attorney


Traditional estate planning focuses on minimizing the impact and addressing the limitations presented by our federal estate and gift regime. Very limited thought is put into the income tax consequences. This can prove to be a costly mistake – especially given the tax law changes that are looming on the horizon.

The estate and gift tax regime applies to property transfers. Estate and gift tax planning often consists of reducing the amount of estate and gift taxes payable so that the maximum amount of wealth and property can pass to lower generations. The issue that many estate planners do not address is whether the estate plan will deliver this wealth and property to the lower generations in a way that will put the lower generation in a position to take advantage of income tax planning opportunities.

The income tax is imposed on “gain” inherent in property. “Gain” is equal to the “amount realized” or sales price less the “tax basis.” “Tax basis” is generally equal to the cost that a person paid to acquire property. For example, one share of Berkshire Hathaway purchased in the early 1970’s would have a tax basis of about a hundred dollars. That same share is valued at approximately $1,000,000 today. Thus, if this stock were sold today it would produce approximately $999,900 in taxable “gain.” If the income tax rate applied to this gain is the current 15% capital gains tax rate, the sale would result in approximately $150,000 in federal income taxes (ignoring any state imposed income tax).

Our tax laws provide taxpayers with a way to avoid this tax. Specifically, our current tax laws provide that persons who inherit property will generally take a “tax basis” equal to the fair market value of the inherited property on the date that the person who bequeathed the property died (or six months thereafter). In the example above, the beneficiary selling the Berkshire Hathaway stock would produce no federal income tax because the taxable gain would be $0, which is the sum of a $1,000,000 sales price less a $1,000,000 stepped up tax basis.

As you can see, the strategy under our current (but soon to change) law is to hold on to low basis property until death, so that the lower generation obtains a stepped-up tax basis. This was most beneficial where the property to be transferred was producing tax benefits to the owner prior to his or her death.

For example, a person who owns rental real estate may have been offsetting the taxable income he or she was receiving from the property by claiming depreciation deductions. If the owner were to sell the real property during his or her lifetime, he or she will have to “recapture” or pay back the taxes on the depreciation amounts that he or she claimed. If the real property owner held on to the property until his or her death, and claimed the full depreciation for the property over time, they would not have to recapture or repay the taxes on the depreciation deduction and the inheritor would still get to step up their tax basis in the inherited property.

This “stepped up tax basis” rule will not apply for inheritances received from persons who die in or after the year 2010. Rather, after 2009 the inheritor will take a tax basis in the property equal to the lower of the tax basis that the dieing taxpayer had or the fair market value of the inherited property on the date that the person who bequeathed the property died.

The executor of the estate (or personal representative) will have the ability to allocate a basis increase up to $1,300,000 (and an additional $3,000,000 for property passing to surviving spouses). This $1,300,000 is an aggregate figure for the entire estate, meaning that the $1,300,000 basis increase is all that can be applied to all property of the estate. In other words, there is no $1,300,000 basis increase for each item of property in the estate.

There are a number of planning opportunities and pitfalls presented by these changes. Today’s estate plans should address these issues. Estate planners can address these issues (1) by taking a fresh look at how property can best titled (joint vs. individual, community property vs. separate property, entity vs. no entity, etc.) and (2) by monitoring (a) assets that are or are becoming low basis high appreciation assets (appreciating vs. depreciating assets, depreciable assets vs. non-depreciable assets) and (b) family changes that will present new planning opportunities over time (marriages, deaths, etc.).

This will require many traditional estate planners to substantially retool their estate forms and to keep up with current income tax planning opportunities. By way of example, estate planners will now have to consider how Section 1031 exchanges – an topic that is traditionally though to be outside of the estate tax planning arena — may impact their estate plans. This is particularly true given the coming elimination of the stepped up basis rules. Private Letter Ruling 123314-06 provides an excellent look at how Section 1031 issues may creep into traditional estate planning arena.

This ruling addresses whether a taxpayer is entitled to Section 1031 exchanged tax basis treatment for a transfer of one property that was received as a gift from a mother to the taxpayer for another property that is held in trust for the benefit of the mother (and with the taxpayer receiving a remainder interest in the trust).

Both of these properties were initially transferred to the taxpayer’s mother upon the taxpayer’s father’s death. Thus, the father opted to pass one parcel outright to his surviving spouse and he opted to place the other parcel in trust for the benefit of his spouse.

Today’s estate planner views this scenario in light of qualified disclaimer and qualified terminable interest property rules – with an eye primarily on transfer tax minimization. Thinking ahead a few years, this exact scenario will also raise significant income tax issues – such as the 1030 issue addressed in the letter ruling. If that will not be complicated enough, these issues will also bring with them the state income tax planning opportunities and pitfalls as well.

In the past estate planning attorneys often divided estate plans into those that are tax-motivated and those that are not-tax motivated (with non-tax motivated estate plans consisting primarily of a simple will and/or a revocable trust). The “tax” motivation was primarily based on transfer taxes — not income taxes. Given the new income tax planning opportunities, the old tax-motivated and non-tax motivated schema will have to be tossed aside.

The bottom line is that today’s estate planner will have to build flexibility into their estate plans so that their client’s beneficiaries can take advantage of these types of pure income tax planning opportunities.

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