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Taxes

Q&A: Tax consequences of giving versus bequeathing

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Dear Liz: Someone who expects to be an executor recently wrote to you about a plan to distribute individual pieces of art to family members. Your response addressed the executor’s responsibility to determine the art’s worth before doing so. You also suggested having the parent designate what was to go to whom. What would the consequences be of the parent giving the pieces of art to the intended recipient prior to death? My mother did both; i.e., gave some to me and some to my sister prior to her death, and designated others to be distributed following her death. She had personal rather than financial reasons for doing it this way.

Answer: Let’s say your mom bought a painting from a struggling artist for $500. Later, the artist became famous and the painting’s value rose to $500,000. If she gave you the painting and you sold it, you would have to use the amount she paid — her basis — to determine the taxable profit ($499,500).

If she bequeathed the painting to you instead, the artwork would get a new tax basis which is usually its value on the day she died. You could sell the painting for $500,000 and not owe a dime in taxes.

Few people have artworks that experience that kind of appreciation — or any appreciation, for that matter. The issue of basis most often comes up when people are transferring real estate, stocks or other assets in transactions that are reported to the IRS. If your mom did have valuable works, though, transferring them through bequests could be advisable.

Q&A: Refinancing brings tax questions

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Dear Liz: I recently refinanced my house and got $9,400 cash back. I also received a $2,400 escrow check from my previous mortgage lender. Is this money taxable? Should I put away a certain percentage of it to pay those taxes? My plan is just to put it back into household repairs (fireplace, painting, etc.).

Answer: You got cash back because you took out a larger loan than the one you previously had. You have to pay that money back, so it’s not taxable income. The escrow check represents a refund of money you’d already paid to the first lender. You don’t get taxed on that, either.

Q&A: They want to give the caretaker the house she lives in without imposing a tax burden

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Dear Liz: Our family owns a vacation home. A caretaker for the property lives in a smaller house next door that is also owned by our family. We consider her part of our extended family and would like to show our appreciation when the property is sold. Our wish would be to give the smaller house in which she lives to her as a gift, but we know the annual payment of property taxes would probably be too great a financial burden for her to live there as a retiree. (She is currently in her 50s.) Is there some sort of trust or fund we could set up that would cover her property taxes until her death without adding to her taxable income?

Answer: Yes, but there may be a better solution.

A trust can be set up to pay the property taxes or other property expenses during the caretaker’s lifetime, said Jennifer Sawday, an estate planning attorney in Long Beach. Trusts face high tax rates, however, and cost money to set up and administer. Plus, you have to find people willing to be trustees and backup trustees who are likely to outlive the caretaker. You also must decide what happens to the money when the caretaker passes away.

All these issues are surmountable, of course. Younger members of your family could be trustees, for example, or you could hire professional trustees. The money could be invested conservatively, or in tax-efficient mutual funds, to minimize taxes. Or it could be invested aggressively enough to pay the tax bill and still provide enough income to pay the property expenses.

Another, simpler solution would be to give her the cash outright. Gifts are not taxable to the receiver, so the gift itself would not increase her income taxes. She would have the burden of managing the cash, of course. Like the trust, she could invest to minimize taxes or more aggressively to potentially grow the money and offset inflation. Either way, her tax rates probably would be lower than the trust’s.

An estate planning attorney can help your family discuss the various options and set up the documents to carry out your wishes.

Thursday’s need-to-know money news

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Today’s top story: New Medicare Advantage benefits may be hard to find and to qualify for. Also in the news: 4 questions to ask before refinancing your mortgage, why college aid requests have decreased, and what to do if you haven’t filed your taxes in years.

New Medicare Advantage Benefits May Be Hard to Find — and Qualify For
In 2019, expanded benefits for Medicare Advantage were enabled, but so far few providers offer them.

The Property Line: 4 Questions to Ask Before Refinancing
Would you benefit from refinancing? Answer these four questions to decide.

Why Are Fewer Students Seeking College Aid? They’re Not Going
Undergrad enrollment is down 4%.

What to Do If You Haven’t Filed Your Taxes in Years
You can’t dodge the IRS forever.

Tuesday’s need-to-know money news

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Today’s top story: How to create financial stability in shaky times. Also in the news: A new episode of the SmartMoney podcast on picking the best investing platform and reducing taxes, the Points Nerd on how travel could change after the pandemic, and good money habits that can hurt your credit.

How to Create Financial Stability in Shaky Times
It’s not just about cash flow.

Smart Money Podcast: Reducing Taxes, and Picking the Best Investing Platform
Finding the best platform to suit your needs.

Ask a Points Nerd: How Could Travel Change After the Pandemic?
Here are some predictions for travel trends that could become permanent post-pandemic.

Good Money Habits That Can Hurt Your Credit
Sometimes having a balance is a good thing.

Q&A: Death, taxes and home sales: How to handle the mixture

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Dear Liz: My wife and I bought our house 61 years ago in Southern California. The wife passed away seven years ago, and I became the sole owner. If I should die owning the house, I know my daughter will inherit and her tax basis will be the value of the house on that date. But if I sell the house, I’m not sure what my basis will be. Do I pick up the 50% of what the house was worth on the day my wife died and add to that the 50% of the original purchase price that would be mine? Or is my basis the original price of the house?

Answer: In most states, only your wife’s half of the home would get a new value for tax purposes at her death. In community property states such as California, though, both her half and yours get this step up in tax basis.

Tax basis determines how much taxable profit there might be when property and other assets are sold. For those who aren’t sure how tax basis works, a simplified example might help.

Let’s say Raul and Ramona bought their home for $40,000 in 1959. In 2013, when Ramona died, the home was worth $800,000. Today, it’s worth $1 million.

At her death, Ramona’s half of the home got a new tax basis. Instead of $20,000 (half of the purchase price), her half of the home now has a tax basis of $400,000 (half of its $800,000 value at the time).

In most states, Raul would keep the $20,000 tax basis on his half, so his combined basis in the home would be $420,000. If he should sell the home for $1 million, the profit for tax purposes would be $580,000.

In California and other community property states, the entire house gets a step up in basis to $800,000 when Ramona dies. If Raul sells the house for $1 million, the profit (or capital gain, in tax parlance) would be $200,000.

Of course, there would be no tax owed on this home sale, since Raul can exempt up to $250,000 of home sale profits. Raul could use Ramona’s home sale exclusion, and avoid tax on up to $500,000 of home sale profit, if he sells the home within two years of her death.

If Raul keeps the home until his death, on the other hand, it will get a further step up in tax basis equal to whatever the home’s fair market value is at the time (let’s say $1.2 million). If the daughter sells it for that amount, no capital gain tax would be owed.