Dear Liz: My father died in June, and I inherited part of his stock portfolio. I understand in 2010 there is no estate tax but have heard different opinions (from my tax advisor and two financial advisors) as to what my tax basis will be when the stocks eventually are sold. The opinions are that 1) I will get no step-up in tax basis, so that I will pay tax on the difference between the sale price and what Dad paid for the stocks; 2) that I will get a 100% step-up, so that the stocks will get a new basis based on their value at Dad’s death, which would minimize capital gains taxes; or 3) some combination of the two — basically, a certain portion would have the step-up allowed and the balance would not be eligible for the step-up. Can you clarify?
Answer: You’ll need to talk to the executor of your dad’s estate.
Here’s why. When there is an estate tax in place, the assets in people’s estates get “stepped up” to their value at the time of the person’s death. This is a huge boon to the vast majority of estates. Most people’s estates don’t owe estate taxes, but they still get this favorable tax treatment so that no tax is paid on the gains that occurred during the person’s lifetime.
When the estate tax disappeared for 2010, the step-up rules changed as well. Each estate instead is allowed $1.3 million of step-up, which the executor can allocate any way he or she wants, said estate attorney Burton A. Mitchell of Jeffer Mangels Butler & Mitchell in Los Angeles, although no asset can receive a step-up that’s more than its fair market value.
If your father’s estate had less than $1.3 million of unrealized capital gains, then all of your inherited portfolio gets a step-up in tax basis. If the gains exceed that amount, however, some or none of the portfolio would get the step-up, depending on the executor’s decision.
The executor has to file a form with the IRS outlining how the step-up is allocated. This form is due with the decedent’s final income tax return, Mitchell said.
Dear Liz: My two brothers have taken over managing my 81-year-old mother’s two rental properties. They have told her that a ski vacation she paid for, which she took with their two families, is a business deduction. Same with many other credit card purchases. Are they putting my mother at risk?
Answer: Two other brothers have gotten a lot of heat for charging ski vacations to the company credit card. Their names are Mark and Andrew, and their dad’s name is Bernie Madoff. Ring a bell?
It is possible to combine a vacation with a business trip and deduct some of your own expenses. But writing off family members’ expenses, or even your own transportation costs if the trip was primarily for pleasure, isn’t smart. If she’s ever audited, your mother is going to have a tough time explaining how your brothers’ wine tab and her granddaughter’s skiing lessons qualified as a business expense.
The rules, which can be complicated, are laid out in IRS Publication 463, Travel, Entertainment, Gift and Car Expenses. But your mother clearly needs more than a pamphlet at this point. She should have her own tax professional, preferably a Certified Public Accountant or an enrolled agent familiar with rental property rules, to advise her and review her tax returns. Your brothers are playing fast and loose with tax laws and it’s your mother who could pay a big price if she’s ever audited.
Dear Liz: My husband racked up more than $17,000 in credit card debt and negotiated a settlement for $4,000 last year. We received a 1099-C form for $13,000 of forgiven debt, which we have to claim as income. That puts our modified adjusted gross income over the threshold of being able to claim tuition and college expense deductions for our three kids and myself. We now owe more than $11,000 in taxes and we don’t have the cash to pay. Any advice would be greatly appreciated.
Answer: You may think owing an $11,000 tax bill because you saved $13,000 on a credit bill is bad enough. But the ironies just keep coming.
For many people, the best way to pay an IRS bill when they don’t have the cash is often by credit card or a bank loan such as a home equity line of credit. As the IRS puts it, “The interest rate and any applicable fees charged by a bank or credit card are usually lower than the combination of interest and penalties imposed by the Internal Revenue Code.”
Given your situation, though, you may not have access to a low-rate loan. If not, you’ll need to work something out with the IRS.
If you owe less than $25,000, you can file online for a short-term (120 days) extension or a longer-term installment plan. The IRS penalty for nonpayment is 0.5% a month and the interest rate is 4% a year, or a combined rate of around 10% a year. There is a one-time fee of $105 for installment agreements, although that can be lowered to $52 if you agree to a direct debit from your checking account.
You’ll find more information at http://www.irs.gov/taxtopics/tc202.html.
Whatever you do, don’t use this problem as an excuse not to file your tax return, since the failure-to-file penalty (5% a month) is 10 times as much as the failure-to-pay penalty.
Dear Liz: You responded to the question “Should I take $50,000 from my 401(k) to pay off the debt?” with a resounding no. However, part of the rationale was how much the money could grow if it were left alone. That makes sense for a young person, but how would you answer the same question for someone retired at age 66?
Answer: At that age, you wouldn’t face tax penalties for early withdrawal and you’re probably giving up less in future gains than someone who is younger.
But dipping into a 401(k) to pay unsecured debts may still be a bad move if there is any chance you’ll wind up in Bankruptcy Court, because retirement funds are protected from creditors. It’s also unwise if you would be withdrawing a large part of your nest egg, because this money has to last you the rest of your life.
Dear Liz: I’m an estate-planning attorney and want to expand on the answer you gave to the parent who wanted to give her children money for their educations or a car but was worried about gift taxes.
Your explanation of the federal rule was accurate — only gifts of more than $13,000 per recipient have to be reported, and gift tax isn’t owed until amounts over that exclusion exceed $1 million — but state laws vary. (California levies no gift tax.) In addition, the $13,000-per-person annual exclusion and the $1-million lifetime exclusion is available for each giver, so a married couple could give $26,000 without reducing their lifetime exemptions.
Also, tuition is not considered a gift if paid directly to the school, irrespective of the amount, so the giver could offer to pay tuition directly and then give money separately for a car. Finally, 529 college savings plans are an excellent way to save for a child’s higher education and are often preferable to giving money directly to the children.
Answer: Thanks for the additional information. College savings plans allow people to contribute up to five times the annual gift exclusion amount at one time, meaning generous parents or grandparents could stow $65,000 into a 529 plan in one lump sum (as long as they make no other gifts to the recipient in that five-year period).
Dear Liz: I lost my job 18 months ago. I am 61 and have back pain that keeps me from standing more than 15 minutes or sitting more than two hours before I have to lie down, which limits my job prospects. I arranged a short sale of my home a year ago to avoid a foreclosure, and recently received a 1099-C form from the lender for $99,000 of forgiven debt. Please warn others about this!
Answer: Don’t panic just yet.
Normally when a lender cancels or forgives debt, you have to include the forgiven amount in your income for tax purposes, which can result in a whopping tax bill.
But the federal Mortgage Forgiveness Debt Relief Act of 2007 provides an exception for homeowners who lose a home to foreclosure, sell it for less than they owe in a short sale or have their debt reduced through a mortgage modification.
You still have to report the forgiven debt on IRS Form 982, but it’s typically not included in your income for federal tax purposes if:
- The home was your primary residence (second homes, vacation property and rentals don’t qualify).
- The forgiven debt was $2 million or less ($1 million for a married person filing separately).
- The debt was forgiven in calendar years 2007 through 2012.
For more information, visit the IRS’ website at http://tinyurl.com/5pe43f. Details can also be found in IRS Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments.
You’ll have to do a little research to see what you might owe under your state’s income tax laws, which could differ. California, for example, hasn’t updated its law to conform with the federal law for mortgage forgiveness occurring on or after Jan. 1, 2009, although there are several bills pending in the Legislature to do so.
If you’re in California, you might want to bookmark this Franchise Tax Board page at http://tinyurl.com /yhx89zw and check back before filing your taxes April 15 to see if you get any relief.
Dear Liz: I would like to give my three children monetary gifts they can use for college or a car. I understand that I can give them up to $13,000 as a nontaxable gift. Is that correct? How would I file the tax return, and would I be allowed to pay the tax on their gift?
Answer: It sounds like you’re misunderstanding how the gift tax works.
You could give your kids a monetary gift of any size, and it wouldn’t be taxable to them. But it could have gift tax implications for you.
If you give more than $13,000 to any one person, you’re supposed to file a gift tax return (IRS Form 709) noting the fact. Any amount over $13,000 per person per year is deducted from your lifetime gift tax exemption, currently $1 million. Once you’ve used up that exemption, you would owe tax on any later gifts in excess of $13,000 per person (or whatever the annual exemption is then). You’d have to be really generous to ever pay a tax.
Dear Liz: I am freaking out and losing sleep. I got a letter about five years ago from the IRS telling me I owed it money, so I stopped filing my taxes. Now I feel scared and nervous and don’t know how to fix this. I have my paperwork and want to file all my returns and see how much I owe. I usually get refunds so hopefully the tax bill won’t be too bad, but I just don’t know where to start. Should I hire an attorney or just throw myself on the mercy of the IRS? Money is tighter than ever, but I feel that I can’t move forward until I resolve this issue.
Answer: It’s too late for you, but others who may be tempted to ignore their obligation to file tax returns need to know two things.
The first is that the failure-to-file penalty is much worse than the failure-to-pay penalty. Since the IRS offers payment plans, it’s better to file than not, even if you can’t pay right away.
The second is that you have only three years to file a tax return before you lose any refunds to which you might have been entitled.
In short, not filing can cost you, big time. You don’t need to throw yourself on the IRS’ mercy, but you should find a good tax preparer who has dealt with this issue before. Many have, as there seems to be no shortage of people like you. Your local certified public accountant society or the National Assn. of Enrolled Agents, at www.naea.org, can provide referrals.
Dear Liz: When the stock market dropped this past year, I decided that was a perfect time to max out my 401(k) deduction to the plan’s 35% limit. The problem is that the IRS maximum contribution is $16,500, and it’s nearly impossible to get my withholding to exactly match the dollar limit. If I am slightly over the maximum at the end of the year, what is the IRS likely to do to me?
Answer: It’s typically not the IRS that takes action in these situations; it’s the 401(k) plan administrator that will either stop your contributions once you hit $16,500 for the year or send you back a check for any amount over the limit you’ve contributed.
You’ll have to pay regular income taxes on that money, but you won’t otherwise be penalized for trying to be aggressive about your retirement savings.