Facts About Gift & Estate Taxes

by Kosmo on 2012-03-040

It’s better to give than to receive. Yet the giver is taxed and the recipient is not. To the frustration of many, the government’s desire for your money doesn’t stop when you die.

If you’re unfamiliar with the specifics of gift and estate tax, you may be confused about why they are being lumped into the same article. Naturally, it’s because the government has decided to tie them together. There is a unified credit — essentially, an exemption — that applies to both gifts and estates. If you make taxable gifts, this can erode the credit that can be applied to your estate when you die.

Gift Taxes: An Example

Not all gifts are taxable. Up to $13,000 per donor, per donee may be gifted tax free each year (this is the current limit). What does this mean, exactly? Let’s say that I’m the rich and generous sort. My wife and I (donors) decide to give some money to SVB (who runs this site) and her husband, The Digerati Spouse. (You’re welcome, SVB. The check is in the mail.) How much can we give tax-free?

That would be $52,000. Here’s how it breaks down:

  • I give SVB $13,000.
  • I give The Digerati Spouse $13,000.
  • Mrs. Kosmo gives SVB $13,000.
  • Mrs. Kosmo gives The Digerati Spouse $13,000.

As you can see, there are four distinct relationships.

Filing A Gift Tax Return

But what if you want to give more? Sure, you can do that — but it will be taxable, and you’ll have to file a gift tax return. Flexible organization that they are, the IRS gives you two options. You can pay the tax now, or you can reduce the amount of your unified credit by the taxable amount. The unified credit is currently $5.12 million (this number is not etched in stone and may one day be subject to future changes). Thus, if you make a gift of $15,000, you would reduce the unified credit by $2,000, leaving only $5,118,000 of the $5,120,000 credit left for your estate.

So which is the better option? Your mileage may vary, but I’d make the IRS wait and opt not to pay the tax up front. Even if you think you’ll have a taxable estate, you may be wrong — things can change over time, after all. Also, if you end up being subject to estate tax, you’ll be dead anyway!

Now there’s also a catch. Of course there’s a catch. We’re talking about the government.

If you give an appreciated asset, your basis becomes the recipient’s basis. Let’s say you buy a share of stock for $10 and give it to me when it’s trading for $100. The price dips to $50 and I sell it. Congratulations — I just incurred a $40 capital gain! How? I sold for $50 and my basis in the stock was the $10 you paid.

This may sound reasonable … except that if I had inherited the stock, my basis would have been $100 and I would have had a $50 capital loss. You should exercise caution when gifting appreciated assets, as you may put the recipient in a worse position than if they had inherited the asset.

We’ve been talking about gifts to people. Gifts to charitable organizations are not subject to gift tax and are even tax deductible. And no, before you ask, gifts to people are not tax deductible.

Dealing With Estate Taxes

We mentioned the unified credit in the gift tax section. This amount is $5.12 million for 2012. That’s up significantly from the $2 million in 2008 — but this is scheduled to drop back down to $1 million in 2013 unless congress acts to increase this amount (which is likely). The top estate tax rate is currently 35%. Politicians like to play around with the estate tax rates and exemption amount on a fairly regular basis, so this may change a lot between now and the time you die.

A key benefit of inheriting property is that you receive a “stepped up basis” in the property. If you inherit stock that someone paid $1,000 for, but which now has a value of $10,000, your basis in the stock is $10,000. If you later sell the stock for $11,000, you have a capital gain of just $1,000. By contrast, if you received the stock as a gift, your basis would be $1,000, meaning that selling the stock for $11,000 would trigger a $10,000 capital gain.

Several years ago, my parents were planning to sell their small dairy farm, which they had purchased nearly 35 years earlier. My father was diagnosed with lung cancer and died very shortly after the diagnosis. The farm was sold a couple of months later. The timing of the events ended up saving my mom a significant amount of capital gains. She inherited the half that the farm deemed to be owned by my dad and as a result received a stepped-up basis on that half.

When she sold the property, she incurred capital gains on “her half” of the farm, but none on the half she inherited — effectively cutting her capital gains in half. Saving money on taxes wasn’t much consolation for the loss of my dad, but it should make you think about whether you should sell assets that have appreciated significantly, or allow them to become part of your estate.

What’s Included In Your Estate?

Let’s start with what’s not included in your estate.

  • Charitable contributions, funeral expenses, claims against the estate, and costs for the administration of the estate are not included in the estate’s overall value. This makes sense, since many of these items are basically outstanding debts that should be addressed first.
  • The big exclusion — transfers to a surviving spouse. With few exceptions (notably, spouses who are not U.S. citizens), an unlimited amount can be transferred to your surviving spouse. Also, any unused portion of the unified credit passes to the spouse. This means that if you died and have a taxable estate of $3 million, the unused portion ($2.12 million) passes to your spouse, giving him or her a unified credit of $7.24 million ($2.12 plus the standard unified credit of $5.12 million).

So, then, what IS included?

  • In addition to the normal assets of the individual, life insurance proceeds are included if the estate was the beneficiary or if the person who died was the owner of the policy, even if someone else was the beneficiary. The owner of a life insurance policy is the person who has the authority to make changes. The beneficiary is the person who receives the money.
  • Assets that are transferred upon death (such as a “payable on death” account) are not included in the probate process, but are considered to be part of your estate.

Congress And Estate Tax Rules

Congress often sets up tax-related laws to expire in the future unless the future congress passes legislation to extend the law. The estate tax was set to be repealed in 2010 unless reinstated by congress. Even with the parties at each others’ necks, I fully expected to see a new estate tax law for 2010. After all, this was essentially a tax on dead people, and dead people have very little voting power (outside of Chicago).

But the impossible happened. There was no estate tax in 2010. A billion dollar estate could have been transferred without incurring a penny of federal estate tax!

What’s the catch, you ask? Yeah, there’s a catch. The 2010 rules provide a limited stepped up basis — up to $1.3 million in assets, with an extra $3 million for assets inherited by a spouse. Estates that were larger than this would have to allocate the available stepped-up basis to specific assets. By contrast, the estate tax became applicable in 2011. So someone dying in 2011 could have passed an estate of $5 million to heirs without incurring federal estate taxes, and the heirs would have all received a stepped up basis (a better deal and improved basis) on the assets. Now if someone instead passes a billion dollar estate to their spouse, their spouse would receive a stepped-up basis on the entire estate. Suffice it to say that a person’s tax liability could be significantly different under the two sets of rules.

Let’s look at an example involving people that died in 2010 and 2011.

Sarah dies in 2010, leaving an estate of $5 million. She had invested in a company on the ground floor, and her basis was a mere $100,000. She left her entire estate to the cashier at the corner gas station. Sarah’s estate did not incur any federal estate taxes, and the gas station cashier received the limited stepped-up basis of $1.3 million. When he later sold the stock for $5,000,001, he had a capital gain of $3,700,001.

Amy dies in 2011, leaving an estate of $5 million. She had invested in a company on the ground floor, and her basis was a mere $100,000. She left her entire estate to the cashier at the corner gas station. Amy’s estate did not incur any federal estate taxes, and the gas station cashier got a stepped up basis of $5 million. When he later sold the stock for $5,000,001 he had a capital gain of $1.

So did congress do anything to address this inequality? Surprisingly, yes. The Tax Relief Act of 2010 allowed executors of estates for people who died in 2010 the opportunity to choose between the 2010 and 2011 estate tax rules.

So Is This All? Well, There’s Your State Estate Tax…

No, of course not. This just covers the federal taxes. The states have their own taxes. It’s very much a mixed bag of how things work. Some states automatically exempt an estate that incurs no federal estate tax. Other states don’t tax the portion of the estate that goes to close family members, or taxes this at a lower rate. Finally, some states simply impose a flat tax on the entire estate. If you incur state estate taxes, these can be deducted from your gross estate to determine your taxable estate for federal purposes.

If you think you have a taxable estate, I recommend discussing your situation with a lawyer who specializes in estate law. While this article should give you a foundation in estate tax matters, it’s just that — a foundation. I’m not able to anticipate and address every possible exception within this article. If you have an estate substantially below $5 million, you should be fine. If you think your estate may be above that amount, this is when advance planning can help minimize estate taxes (by making gifts before death, for example).

Copyright © 2012 The Digerati Life. All Rights Reserved.

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