Planning for property tax for heirs.

Posted in Planning, Tax planning at 9:44 am

Let’s continue to consider the example described in the previous post – Mom and Dad buy their home for $100,000 in 1970. Given California’s property tax scheme, as modified by Proposition 13, Mom and Dad will pay state and local property taxes of approximately 1.1% of the assessed value of their home every year – and the assessed value of the home is artificially limited to a growth rate of 2% per year, unless and until the home is sold, at which time it’ll reset to the real fair market value.

In practical terms, this means that Mom & Dad, in 2006, will probably be paying property taxes of between $1,000 and $1,500 per year on their home that’s worth $1,000,000. Let’s imagine another couple purchases the home next door to Mom & Dad, which turns out to be identical to Mom & Dad’s house – and the fair market value (FMV) is also $1,000,000. The new couple will pay approximately $10,000 per year in property tax, where Mom & Dad will pay closer to $1,000.

This ability to retain the old assessed value represents a considerable opportunity to avoid paying property taxes.

An important part of estate planning – often overlooked by attorneys who don’t spend a lot of time working on estate plans, and virtually always overlooked by do-it-yourself software kits and books – is working to preserve the opportunity for heirs to keep the favorable low property tax valuation, in the event that the heirs choose to continue to own the property instead of selling it.

As discussed in the previous message, let’s say that Mom stays in the home after Dad’s passing, and that when Mom passes away the home is now worth $1,500,000. Mom’s estate plan provides that the home will go to her son and her daughter, each taking a 50% interest.

Son and Daughter will get to keep Mom’s favorable property tax valuation; California law provides that property tax will not be reassessed on a transfer between parents and children. The transfer of 1/2 of the property from Mom to Son and 1/2 of the property from Mom to Daughter qualifies as a transfer that’s exempt from reassessment.

Let’s say that Daughter’s already got a house she wants to stay in – but Son wants to live in the family home, so he arranges to get a mortgage so he can purchase Sister’s half from her, and Son can own the home as his own.

The wrong way to set this up is the obvious way – Son buys the other half of the house from Daughter. Now, Son will get to use the favorable valuation for the half of the property he inherited from Mom, since that was an exempt transfer .. but the half of the house that Son purchased from Daughter will be reassessed, because sibling-to-sibling transfers aren’t exempt. Now, instead of paying a property tax bill of $1000 to $1500 per year, Son’s property tax bill will be more like $8000 per year (1/2 of $1,000 + 1/2 of $15,000).

If Son keeps the family home for 20 more years, the failure to plan for favorable property tax treatment will cost Son $140,000 in extra property taxes. If Son then passes the property on to his children at his death, then his kids will be paying property tax bills of $8000 instead of $1000, and the waste continues.
Unfortunately, this approach is what you’re likely to end up with if you (or your attorney, or your do-it-yourself software) aren’t paying attention to property tax planning – it’s easy to conclude “well, there are no estate tax issues here” and stop thinking. That decision to stop thinking can cost heirs an awful lot of money pretty quickly.

This isn’t a hypothetical example – I have worked on several cases where the estate plan was drafted by an attorney (or worse, an annuity salesperson) who didn’t know or care about property tax, and the consequence is tens or hundreds of thousands of dollars in unnecessary property taxes for the heirs.


Planning for income tax for heirs.

Posted in Planning, Tax planning at 9:52 am

It’s tempting to compare one’s assets to the exemption amounts for federal estate tax ($2 million in 2006, 2007, 2008) and conclude that there are no tax issues in planning one’s estate (or failing to plan).

Unfortunately, that’s only part of the story.

One often underappreciated aspect of estate planning is planning for income tax implications for heirs – ideally, one would like to give heirs assets that are subject to as little tax as possible. Most property that appreciates – for example, real estate, collectibles, and securities (stocks & mutual funds) get what’s called a “step up” in basis when it’s transferred at death.

For example, let’s say that Dad has a share of stock he bought long ago for $10 – the stock is now worth $100. If Dad sells that share of stock, he’ll owe income tax on the $90 of profit he made while holding the stock. The $10 purchase price (which may have been adjusted due to stock splits, reinvested dividends, and so forth) is what tax people call Dad’s “basis” in the stock.

Let’s also assume that Dad wants to give that share of stock to his daughter. If Dad gives that share of stock during Dad’s lifetime to Daughter, Daughter will get what’s called “carryover basis” – that means that Daughter’s basis in the stock will be the same as Dad’s basis, which was $10. If Daughter immediately sells the stock, she’ll also have to pay tax on the $90 of built-in profit.
However, if Dad keeps the stock and gives it to Daughter upon his death – either through a trust, or through a will – then the stock gets the “step-up” in basis, and Daughter’s new basis in the stock is the fair market value on the date that Dad died. This means that if Daughter immediately sells the stock, she’ll have (virtually) no tax to pay, since her basis (fair market value) will be very close to the sale price. Daughter may have a small gain or a small loss on the stock, but it won’t be very big if she sells the stock relatively quickly.

The same treatment applies to other property that appreciates – like real estate or collectibles.

Some property – like cash – is valued at its face value, so it doesn’t make sense to talk about getting a “step up basis” in, say, a bank account.

This sounds great, right? Well, there’s a catch. The only property that gets a step-up in basis is property that’s included in Dad’s “taxable estate” at his death. The good news is that the vast majority of people may have a “taxable estate” but pay no tax, because they get an exemption equal to the tax on the first $2 million of property (for people who die in 2006, 2007, 2008). So .. this means that Dad can pass along up to $2 million in property, all of which gets a step-up in basis for income tax purporses, without owing any estate tax.

If Dad passes more than $2 million in property to others at his death, then his estate will owe tax on the amounts above $2 million – unless the amounts beyond $2 million are given to recipients who have special exemptions. (Specifically, charities and Dad’s spouse, if she’s a US citizen. Charities and spouses who are US citizens can receive an unlimited amount of property at death without any estate tax obligations.)

In my practice, I find that most people notice (and appreciate) the step-up in basis when it is applied to real property. Specifically, the step-up in basis is very helpful to surviving spouses, especially if the shared home was titled as community property. When property is titled as community property, the entire property gets a step-up in basis upon the death of the first spouse.

Let’s say that Mom and Dad bought their house in 1970 for $100,000. Today, the house is worth $1,000,000. (These numbers will look crazy to non-California readers; but they’re not unusual for middle-class people here in Silicon Valley.)

If Mom and Dad sell the house, they’re going to have to pay tax on approximately $400,000 of capital gain – they can exclude the first $500,000 in capital gain when they sell their principal residence, but they’ve got $900,000 in profit – so they’ve still got another $400,000 that they’ll have to pay tax on.

Men tend to have shorter lifespans, so let’s suppose that Dad passes away first. Now – because of the step-up in basis and holding title as community property – Mom’s new basis in the home is $1,000,000. Mom can sell the house and her profit will be zero – so no tax will be due. Let’s say that Mom stays in the house 5 more years – and during those 5 years, the house appreciates another $200,000 in value, to $1,200,000. Mom can still sell the house without having a tax bill to worry about, since she’s got her $250,000 exclusion – applied to the $200,000 profit above Mom’s basis of $1,000,000, there’s still no taxable gain.

But let’s imagine that Mom doesn’t sell the house – Mom lives 10 more years, and the house appreciates in value to $1,500,000. Mom dies, leaving the house to her two kids. If the house is included in Mom’s taxable estate, the kids will get the step-up in basis again – so their basis in the house will be $1,500,000 (or, each kid will have a basis of $750,000 in their half of the house). This means that the kids, if they choose to sell the house, can keep the $750,000 each – with no estate tax, and no income tax due. That’s a pretty nice result, given that Mom & Dad’s original investment in the house was $100,000. $1.4 million in appreciation has passed to the children, tax-free, perfectly legally.


Suze Orman and Estate Planning

Posted in Living trusts, Planning, Wills at 1:27 am

Professor Gerry Beyer mentions that QVC is offering a $60 Suze Orman estate planning organizer – where “organizer” apparently means “plastic briefcase with LED flashlight built into the handle”. Sounds perfect for Maxwell Smart or Inspector Gadget.

If you can live without the plastic briefcase, you can get Suze Orman’s estate planning software from Amazon.com for approximately $14.

The downside is that you get what you pay for – specifically, you’ll get a document you can’t edit that specifies that it should be interpreted using California law. This is not especially remarkable if you are a California resident, as that’s probably what you intended.

On the other hand, if you happen to live in one of the other 49 states, it’s setting you up for an ugly surprise if administration of the trust or estate turns out to be anything other than perfectly smooth – because it’s going to be difficult and/or expensive to find someone in your state who’s also licensed in California and stays current regarding California trust law. If it turns out that there’s litigation regarding the trust, you’ll get to pay that expensive attorney even more than you otherwise would, because they’re going to have to spend extra time writing a detailed brief for the judge explaining California law .. since it’s pretty unlikely that you’ll randomly get assigned a local judge who’s got any knowledge about California law.

California law strikes me as an especially poor choice of law if someone was going to try to draft a “universal trust” since California law is essentially homegrown. California has not adopted the Uniform Trust Code and I don’t believe it will, though 19 other states have.

The marketing material says the resulting documents are “good in all 50 states” – which is literally true, but totally misleading. When I speak with someone who wants to bring an out-of-state trust into California, my advice is to amend and restate it to use California law for ease of understanding and administration. In a similar vein, when I talk to potential clients who live (or expect to live) in another state, my advice to them is that they not pay me to draft an estate plan, but that they seek a good estate planning attorney in their (intended) home state, who will know the local tricks and pitfalls.

“Good in all 50 states” is the legal equivalent of “one size fits all” – it’s a giant warning that what you’re getting wasn’t intended specifically for you, and if it happens to work out well it’s a happy accident.

I think it’d probably be better if the Suze Orman trust didn’t specify a state’s law at all – or if it chose the law of the state where the user lived, even if it means that the person who wrote the software doesn’t know how the language will be interpreted. Frankly, I don’t see how the person who wrote the software can have any faith that, say, a New York judge will reach a reasonable result under California law trying to interpret a do-it-yourself trust for a New York resident. (Nothing against New York, I wouldn’t want to try to litigate a trust that specified New York law in a California courtroom, either.) I gather that choosing California law allows the attorney involved in publishing the software to avoid the charge that she’s trying to practice law in states where she’s not admitted to practice .. but while that trick may save her bacon, it puts people who buy the software in a terrible posture.