Ask Liz Weston

Get smart with your money

Taxes

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.

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.

Home sale tax break won’t disappear

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Dear Liz: My wife and I are trying to sell our home, which has been our primary residence for six years. I am very concerned about the $500,000 capital gains exclusion. As I understand it, the exclusion would mean we wouldn’t have to pay taxes on our home sale profit. But we are confused about this exemption being tied to the “Bush tax cuts” that could expire Dec. 31. If we sell our home after that, could we lose the exemption?

Answer: No. The law creating a capital gains exemption for home sales went into effect May 6, 1997. It’s not tied to the tax cuts approved during President George W. Bush’s tenure that are set to expire at the end of the year.

So people who live in a home for at least two of the previous five years will still be able to avoid paying capital gains on their first $250,000 of home sale profit (or $500,000 for a married couple).

Another tax you likely won’t have to pay is a new 3.8% levy on what’s called “net investment income.” Some emails circulating on the Internet falsely claim that the tax, which is scheduled to kick in Jan. 1, is a real estate sales tax. In reality, it’s a potential tax on home sale profits that exceed the capital gains exemption limit, as well as on other so-called unearned income, including investment and rental income.

If your home sale profit doesn’t exceed the capital gains exemption limit, you won’t owe the new tax. If your profit does exceed the limit, the excess amount would be added to your adjusted gross incomes to determine whether you’d have to pay it. The 3.8% tax would be levied only on people whose adjusted gross incomes are more than $200,000 for singles and $250,000 for married couples.

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.

Parents’ estate plan triggers IRA tax bill

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Dear Liz: My sister and I are in the middle of distributing our parents’ estate. The beneficiary of the estate is a trust. Part of the estate consists of a traditional IRA, which will be split between my sister and me. The problem is that because the IRA will be distributed from the trust and is considered a non-spouse distribution, I’m told that we’ll have to pay taxes on the entire distribution. It’s a good chunk of change. I’m almost 60. Is there any way that I can roll the IRA into my own and take minimum distributions? I’d rather not pay the tax all upfront.

Answer: That’s understandable, since it’s typically much better to stretch distributions out as long as possible so that the money can continue to grow (and you can replace one big tax bill with smaller ones as you take distributions).

Unfortunately, the way your parents structured their estate ties your hands, although perhaps not to the extent you’ve been told.

It appears from your question that the IRA either failed to name a beneficiary or named the estate as the beneficiary, said Mark Luscombe, principal federal tax analyst for tax research firm CCH.

“Assuming that is the case, since estates do not have life expectancies, the IRA cannot be distributed over a beneficiary life expectancy as it could have been had an individual been named the IRA beneficiary,” Luscombe said. “Instead, it must be distributed under the terms of the IRA document over a period that cannot exceed five years.”

The exception is if the IRA owner before dying had already reached the age of 701/2 and begun distributions, Luscombe said. In that case, distributions can continue to the estate over the IRA owner’s life expectancy. If the IRA owner was quite elderly when he or she died, this might not give you much time to stretch out the distributions, but it probably would be better than paying all the taxes at once.

Another exception, which doesn’t appear to apply in your case, is if the IRA named the trust as the beneficiary. If that were true, “it is possible that the distributions could be based on the life expectancy of the oldest trust beneficiary,” Luscombe noted.

As you can see, this is a complicated area of estate planning and taxation. Getting good advice about how to name beneficiaries for your accounts can save your heirs a lot of money.

Get advice before transferring house deed

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Dear Liz: My mother will be 88 in August. She owns her own condo, which is worth about $95,000, and has $5,000 in life insurance. She is in good health and lives comfortably on a monthly pension. She wants to put her condo in the names of my brothers and myself. What is your advice?

Answer: This is probably a bad idea for a couple of reasons. You and your siblings wouldn’t get the “step up” in tax basis that would be available if you inherited the property. In other words, you might owe capital gains taxes when you sell that could have been avoided if you had inherited the property rather than received it as a gift.

A potentially bigger issue: Medicaid look-back rules. If your mom needs nursing home care, her eligibility for the government program that pays for such care could be compromised by such a transfer. Many elderly people transfer their homes to children hoping to “hide” the asset from Medicaid, but all such transfers typically do is delay the older person’s eligibility for help.

Before she does anything, take her to an elder-law attorney who can help her — and you — plan sensibly for her future. You can get referrals from the National Academy of Elder Law Attorneys at http://www.naela.org.