Ask Liz Weston

Get smart with your money

Estate Planning

Myths about “death taxes” lead to costly mistakes

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Dear Liz: You recently answered a question about capital gains taxes that stemmed from two siblings selling their parents’ home. The children had been added to the parents’ deed, presumably before the parents’ death. You mentioned that the capital gains tax would have been avoided if the parents had bequeathed the home rather than gifting it during their lifetimes. Presumably bequeathing the home at death would have necessitated probate and incurred inheritance taxes. Are these costs more than offset by the stepped-up tax basis received?

Answer: Your questions illustrate exactly why no parent should add a child (or anyone else) to a home deed without discussing the issue with an estate-planning attorney first. Too often, laypeople misunderstand what’s involved in probate and make expensive mistakes trying to avoid it.

In some states, probate — the court process that typically follows death — is relatively swift and not very expensive. Trying to avoid it isn’t necessarily cost effective. In other states, including California, the process potentially can take many months and eat up a good chunk of an estate. When that’s the case, it can be prudent to take steps during life to sidestep probate at death.

There are often better ways to do so, however, than adding someone to a deed. A living trust, for example, can be a good way to avoid probate and preserve the tax benefits of bequeathing, rather than gifting, assets. Living trusts can vary in cost, but a lawyer can typically set one up for $2,000 or $3,000. If you compare that with the $25,000 or more the siblings will pay in capital gains on a relatively modest home sale, you can see that the living trust probably is a better deal.

Now let’s turn to the issue of estate taxes. If the assets left by the deceased are substantial enough to incur estate taxes, they will do so whether or not the estate goes through probate. Avoiding probate, in other words, does not avoid estate taxes. Currently, only estates worth more than $5.12 million face federal estate taxes. That limit is scheduled to drop next year to $1 million, but will still affect relatively few estates.

Get a lawyer’s advice before transferring home

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Dear Liz: Your column on the tax issues that develop when parents deed their property to their children should help educate a lot of people. But sometimes this is done to reduce the parents’ assets so they will be eligible for Medicaid after the expiration of the look-back period. In this case, paying the capital gains tax is appropriate, because they are asking the state to pay potentially very large senior care bills.

Answer: Some would question whether it’s ever appropriate for seniors to deliberately impoverish themselves by transferring away assets in order to qualify for Medicaid, which pays long-term care expenses for the indigent. The “look back” period, in which states examine asset transfers before a Medicaid application, was established to discourage such maneuvers. Once again, it’s smart to get a legal opinion before transferring big assets. An elder-law attorney could weigh in on the pros and cons of Medicaid planning.

Gifting home creates unnecessary tax bill

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Dear Liz: My wife and her brother are selling their parents’ home. The parents transferred the deed to their children’s names years ago. My wife should receive about $85,000 from the sale. Our yearly income (one salary; she’s a stay-at-home mom) is around $75,000. My wife is worried about capital gains taxes and wants to reinvest in another real estate property because she’s heard that that will eliminate the capital gains tax. Is that correct? I would really rather invest that money in our current home (finish the basement into a family room, update some items) and pay off our car loan than worry about another property to take care of. What do you think?

Answer: A 1031 exchange is a tax maneuver that allows owners of business or investment property to swap the real estate they have with another property, a transaction that can defer (but not necessarily eliminate) capital gains taxes.

It’s questionable whether your in-laws’ home would qualify as business or investment property, said Mark Luscombe, principal federal tax analyst for tax research firm CCH.

“Were the parents paying rent to the children after the title was passed to the children? If the kids owned the property and the parents were living there without paying rent, I do not think that would constitute investment property,” Luscombe said. “Perhaps if the parents were still paying upkeep expenses and real estate taxes, that might approach the equivalence of rent.”

If there’s a chance the property might qualify, your wife should consult a tax pro experienced with 1031 exchanges for details. Otherwise, she’ll need to write some good-sized checks to the tax authorities. Currently the federal capital gains tax rate is a maximum of 15%, although it will rise to 20% on Jan. 1 if Congress doesn’t reach a compromise on the so-called fiscal cliff. Add to that any state or local taxes on capital gains.

You may think of these taxes as a small price to pay compared with the risk of owning a piece of rental property. Your wife may have another concern that she has not voiced, however: She may not want this legacy from her parents to disappear into the general family budget. She may feel an obligation to preserve and try to grow the money, rather than sinking it into home improvements and other consumption. Legally, gifts and inheritances are considered separate property owned only by the spouse to whom they were given, even in community property states where most other assets are considered jointly owned.

If she wants to keep this money separate, in other words, that’s her right. It would be nice if she carved out a small chunk for family consumption, but she’s under no obligation to do so. If a 1031 exchange isn’t possible or feasible, then she could consult a fee-only planner about other ways to invest the money for the future.

By the way, it needs to be said: This tax bill was avoidable. If your in-laws had, instead of gifting the property, waited and bequeathed it at their deaths, the home would have received a so-called step-up in tax basis. Such a step-up in effect eliminates the need to pay capital gains taxes on any home price appreciation that occurred during the parents’ lives. Any parent thinking of adding a child’s name to a real estate deed should first consult an estate planning attorney to understand the ramifications, since gifting property this way can be an expensive mistake.

Don’t expect surviving spouse to “do the right thing”

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Dear Liz: My parents were married for 50 years. When my mother died, my father didn’t inherit a large monetary fortune, but he did get a houseful of family treasures (photos, knickknacks, mementos, documents) that had been cherished and saved for me and my children (I was an only child). Immediately after my mom died, my father found a lady friend and cut off all ties with me and his past. I tried but could not get through.

I know it would not have been my grandparents’ or my mother’s wishes that 150 years of family memories be lost, but unfortunately that is how it turned out. Please encourage aging parents to plan ahead for many potential outcomes so that their wishes and the wishes of past and future generations are honored. I shudder to think of what has happened to my great-grandmother’s journal that I read aloud as a child.

Answer: The German fairy tale about Hansel and Gretel resonates with many people in your situation. If you remember, in that tale a poor woodcutter acquiesces to his second wife’s demand that he abandon his children to die in the woods.

Of course, that tale ends happily. The children kill the evil witch who imprisons them. They steal her jewels and return to share the wealth with their once-again-widowed father. (Children can be remarkably forgiving.)

It’s sad that you’ve lost access to the heirlooms, but it’s much sadder that you’ve lost access to your father. If he’s still alive, though, so is the possibility of rapprochement. If you keep in touch, he may eventually thaw. If not, you’ll at least know you did all you could.

Your mother may not have been able to imagine your father cutting you off the way he has. But expecting a surviving spouse to “do the right thing” in distributing heirlooms may be expecting too much. Dementia could rob the survivor of good judgment, or he could be influenced by a subsequent relationship, as your father was.

So your point is well taken. Anyone who has heirlooms to pass along should make sure to do so — either in a will or, better yet, while still alive to enjoy the next generation’s appreciation.

Anyone who’s lost access to an heirloom should remember that while precious, it’s still a thing — and a thing that could have been lost in many other ways, from a house fire to negligence. Focusing on the loss won’t bring the thing back or restore a troubled relationship. It will just make you unhappy, and life’s too short for that.

Wealthy families may be missing an opportunity to save

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This post won’t be relevant to the vast majority of you. But if you’re rich or have rich parents, listen up.

There’s a window of opportunity right now to reduce future estate taxes by moving money out of large estates. People who don’t take action could be missing a chance to save their heirs a bundle.

Here’s the deal: Currently, the estate tax exemption limit and the gift tax exemption limit are both $5.12 million. Both are scheduled to revert to $1 million after Dec. 31.

What that means is that wealthy people can give over $5 million away (over $10 million for a married couple) without owing any gift tax on that transfer. Such gifts can reduce the size of the wealthy person’s estate, so that the estate tax bill will be lower when he or she dies.

The money can be given away directly, or put into certain kinds of trusts. Any good estate planning attorney can outline the possibilities. If you’re planning to pass money to your kids, or a business, or real estate, it’s worth reviewing these.

Interestingly, a recent survey from U.S. Trust found two-thirds of the wealthy folks it polled hadn’t taken advantage of this opportunity and didn’t plan to do so. The survey respondents all had a minimum of $3 million in investable assets, with 31% having $5 million to $10 million and 32% having more than $10 million.

Now, it’s possible that Congress with pass some kind of patch or extension of the current exemption limits. It hasn’t been able to agree on much late, of course, but that can always change.

Still, if you’re concerned about estate taxes, it would make sense to meet with both a fee-only financial planner (to see if you can afford to give money away) and an estate planning attorney to see if it makes sense to pass some money along to your heirs now, rather than waiting until death.

Bypass trust can get money to the right heirs, eventually

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Dear Liz: We married late in life and each of us brought separate property to the marriage. One spouse has four children and the other none. We have a marital trust that allows for the spouse upon death to receive the entire estate. Upon the death of both spouses, how would you draft a provision that would allow the remainder of one spouse’s separate property to be allocated to her children and the other spouse’s separate property to be donated to a charitable foundation?

Answer: Instead of allowing each other to inherit everything outright, you might want to consider a bypass trust. These trusts allow the surviving spouse to benefit from the assets during his or her lifetime. Upon the surviving spouse’s death, the assets are bequeathed to the ultimate beneficiaries. The survivor can’t alter the trust to change or prevent that.

Bypass trusts can create family tension, however. If the mother in your example were the first to die, her children would have to wait for “their money” until her spouse died. In the case of much younger or unusually healthy spouses, that can be a long wait, with the kids worrying that the surviving spouse will spend most or all of the money in the meantime.

If that could be an issue in your case, you might consider buying life insurance on the mother, Los Angeles estate planning attorney Burton Mitchell said.

“Some people fund for the children with life insurance on that parent’s life, so that the children don’t have to wait for the second death,” Mitchell said, “and to minimize tension with the children with the surviving spouse.”

You also should consider having a meeting with the children once you’ve decided how to handle this, Mitchell said.

“It is often better for them to understand what is happening and let them ask questions to their parent, before they discover the facts after the funeral,” he said. “At that point, someone is already dead and the survivor’s answers are suspect.”

If your estate is greater than estate tax exemption limits — currently $5.12 million, but scheduled to drop to $1 million in 2013 — you may want to take additional steps to reduce the future tax bite. One option is known as a qualified terminable interest property or QTIP trust. Your estate planning attorney can provide you with details. And yes, you should have an attorney, particularly if you have a large estate or someone may contest the will.

“Anyone can download documents off the Internet or go to a forms service or mill, but to do it right and to minimize problems later, you have to understand each individual’s situation and craft a plan that works best for them,” Burton said. “It’s like snowflakes — estate plans may look similar, but no two should be identical.”