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Monday, December 28, 2009

So, Will there be a Federal Estate Tax in 2010?

On December 3, the House of Representatives passed a bill to permanently extend the Federal Estate Tax Exemption (H.R. 4154). The current exemption is $3.5 Million per person, or $7 Million for a couple, with a 45% tax on the decedent's assets over the exemption amount.

As of yesterday though, the Senate has yet to act, which means that the law passed by President Bush in 2001 remains in effect. If Senate does not pass bill to deal with this by New Year's, that will mean that on January 1, 2010 there will be no federal estate tax - maybe.

Why do I say maybe? Because it is still very likely that Congress will act after the new year to reinstate the tax, and make it retroactive to January 1st. They've done it before, with the permission of the Supreme Court. (see U.S. v. Carlton)

Even more troubling, the repeal would only be for one year, and then the exemption amount would come crashing back down to One Million Dollars (indexed for inflation) in 2011. This does not make for easy planning and will most adversely affect individuals who have children from one relationship and are now married to a different person. People who are in this situation should seek out an estate planning attorney immediately because it is likely the formulas in their Wills may cause a disastrous result. Many formulas can be read so that either the children from the prior relationship are completely cut out or the new spouse is completely cut out. There is an easy fix to this by setting caps on how much a spouse or child can get, but I reiterate - many old formulas will not work.

Most estate planning practitioners that I know still strongly believe that the government will pass a law to keep some form of estate tax - mainly because we find it hard to believe that the government will give up so much money from the people who can most easily afford to pay it. However, for those of you who have been completely ignoring the issue, it is time to start paying attention because a complete repeal of the federal estate tax will actually have a large capital gains tax consequence.

To understand this capital gains tax consequence, you must first understand and appreciate the incredible importance of "Basis". If the federal estate tax is indeed repealed, executors will be entitled, for an individual decedent, to allocate to the decedent's assets up to $1.3 million in basis plus the sum of the decedent's unused capital loss carryovers, net operating loss carryovers and unrealized losses on property owned at the date of death (IRC Section 1022(b)). No asset may be increased in excess of fair market value though.

In addition to the $1.3 million basis increase available to all beneficiaries of an estate, the executor
may allocate another $3 million of basis to assets passing to a surviving spouse. (This benefit only applies to heterosexual couples.)

As a practical matter, the repeal of the estate tax will most negatively affect those few individuals who have a lot of highly appreciated assets and those individuals who might not have had to file a return at all. The reason that it negatively affects the people who might not otherwise had to file a return is because I believe that a return will have to be filed to properly allocate basis to your assets. This will result in extra attorney fees for many.

The pessimist in me says that the government will wait until about August of 2010 or so and make a retroactive law, making estate planning and administration most cumbersome and costly.

Understanding Basis

If you want to sell an asset, particularly a valuable asset, no one should do so without first understanding what the tax consequences of that sale might be. The tax that most often affects the sale of a valuable asset (in a non-business setting), is the capital gains tax. To understand this capital gains tax consequence, you must first understand and appreciate the incredible importance of "Basis".

An asset's basis is often referred to as the amount an asset cost when you buy it. For example, if you buy stock at $20 and sell it at $100, the basis of the stock is $20 and the gain on the sale is $80. If the stock was held for an appropriate time amount, the gain would be considered capital gain and taxed at the capital gains tax rate.

Now, the basis in an asset can change for a variety of reasons. For example, let's say that the stock that you bought split, you would have to split the basis in the stock in the same way that the stock split. Additionally, let's say the asset is a house, or some other type of depreciable asset. Every time you depreciate the asset, the basis is reduced. If, on the other hand, you make capital improvements to the asset, like putting an addition on to a house, that increases the basis of the asset.

So, let's assume that you buy a rental property for $200,000. You spend $100,000 improving it, depreciate it by $80,000, and then ultimately sell it for $750,000. The basis in the property would be $220,000 ($200,000 + $100,000 - $80,000). The gain would be $530,000, and most likely taxed at the capital gains rate of 15%.

Another major factor in determining the basis in property is whether, under current law, a person holds that asset at the time of his or her death. Currently, when a person dies, the heirs take the assets of the decedent with a basis equal to fair market value. (Often times this is called a step up in basis - but that is a bit of a misnomer as the basis can actually be lower in a bad economy.)

So for example, let's say that Dad dies owning a house that he purchased for $350,000, and at the time of his death it is worth $550,000. If the heirs sell the house shortly after his death for $560,000, there is only $10,000 of gain, not $210,000 of gain because of the increase in basis due to Dad's death.

Now let's complicate matters. Dad and Mom own that same property that they bought for $350,000. Dad dies when the value of the property is $400,000 and Mom dies when the value is worth $550,000. The basis in the property will be determined by whom the property was left to. If Mom inherited the property from Dad and then died, the basis of the property is the full $550,000.

If Dad left the property to daughter, and the other half the property went to daughter when Mom died, the basis will be split. The basis will be $475,000 in the hands of daughter. (1/2 of the property with a $200,000 basis as a result of Dad's death and 1/2 of the property with a $275,000 basis as a result of Mom's death.)

I emphasized "under current law" earlier because that may all change on January 1, 2010. In 2001, President Bush passed a law that eliminates the federal estate tax and eliminates the fair market date of death basis rule. There will be another form of capital gains tax exemption that will go into affect that I review in another post.

Lost in the debate over the estate tax is the importance of the rule revaluing property so that it takes on a date of death basis. One of the big problems that people have is keeping proper records of the basis of their assets. Sometimes, assets can be passed down for generations before they are sold. If the owner cannot provide proof of an assets basis, the government will assume the basis is Zero, causing a potentially very large tax.

So while keeping track of the basis of your assets was always important, it may be even more important to safeguard your paperwork pertaining to your valuables if the estate tax is truly repealed.

Thursday, December 3, 2009

A Good Time to Buy that First House – But How?

Many experts think this is a great time to buy a new house, especially if you are a first time home-buyer. Interest rates are low and home values are depressed. The problem, however, with this credit crunch is having enough cash for the down-payment. There are programs out there so that you can buy a home with almost no money down, but that can lead to the monthly payment of Private Mortgage Insurance (PMI), which is expensive, and opens the homeowner to the possibility of owing more than the home is worth if the value declines.

In order to put have an adequate down-payment, many prospective homeowners will consider dipping into their IRAs, 401(k)s or 403(b)s for the down payment. Tapping into these retirement accounts options have significant drawbacks and the cost of such withdrawals should be carefully considered.


Best features:

* You can withdraw up to $10,000 without a 10% early withdrawal penalty. (A husband and wife can each withdraw $10,000 to make a $20,000 down-payment.)
* You may withdraw for immediate family such as a spouse, child, grandchild, parent or other ancestor.


* The withdrawal amount will be taxable as ordinary income.
* There is no ability to re-contribute money.
* Funds can only be used towards: buying, building or rebuilding the primary residence; and any usual or reasonable settlement, financing or other closing costs.


401(k)s and 403(b)s function in very similar fashion to each other. There are 2 ways to access your retirement fund to purchase a home: withdrawing it outright, or taking a loan out against it. It is usually a far better option to borrow against a 401(k)/403(b) than to withdraw from it due to the pitfalls.

1. If you withdraw money from your 401(k)/403(b):

Best features

* You do not have to be a first-time homebuyer to withdraw 401(k)/403(b) funds (any financial hardship as described by the IRS will suffice).


* You need to be purchasing a primary residence, as withdrawals are only permitted under “hardship” circumstances. (The government considers the need to purchase a primary residence as a hardship circumstance.)
* The withdrawal amount will be considered taxable income.
* You will be assessed a 10% early withdrawal penalty if you are under age 59.5.
* You lose the compounding interest.
* You may also be prohibited from making any additional contributions for a period of one year.

2. If you borrow against your 401(k)/403(b):

Best Features

* You may borrow the lesser of $50,000 or ½ of your account balance. However, if ½ your account balance is less than $10,000, it may be possible to borrow $10,000.
* A loan from a 401(k) allows you time to pay it back. (This is usually at prime + 1% and the typical payback period is 10-15 years, but it may be as long as 30 years.) A 403(b) typically has a payback period equal to the duration of the first mortgage. However, you should check the specific payback period identified in your plan.
* There is no penalty for borrowing against your 401(k).
* Assuming that you pay the loan back in a timely manner, there are no adverse income tax consequences to receiving the loan.


* If you lose your job, any unpaid loan amount would either be due in a period as short as 60 days. If you do not pay back the loan, the unpaid amount will be considered income, which is then both taxable and possibly also subject to a 10% early withdrawal penalty.
* Most plans prevent you from contributing extra savings until the loan is repaid.


While IRA, 401(k) and 403(b) funds could be used to fund the deposit on a first time home purchase, the tax drawbacks and risks are significant. You will want to consider how use of these funds will affect your retirement and your estate and the tax implications before taking such drastic measures. Obviously, if you are in your 20s with many years until retirement, and perhaps not at the peak of your earning potential, the use of your IRA and/or 401(k) and/or 403(b) funds can help you buy a piece of the American dream. However, if you are looking towards retirement or the rate of return on these funds makes withdrawing funds a particularly costly proposition, it is best to look elsewhere for your down-payment.

Special thanks to Nancy McMillin in the preparation of this post.

Wednesday, December 2, 2009

Special Needs Planning in NJ - Part 4 of 4

Special Needs Trusts and Supplemental Needs Trusts

In Part IV of this Series, I want to discuss the role of Special Needs Trusts and Supplemental Needs Trusts in estate planning.

"Special Needs Trusts" and "Supplemental Needs Trusts" are terms to describe trusts designed to provide benefits to a person in a way that will preserve the public benefits that he or she is entitled to receive. The person who benefits from the trust is called the beneficiary.

Each special needs trust can be intended to protect different public benefits. Most commonly, special needs trusts are intended to permit Supplemental Security Income (SSI) and Medicaid recipients to receive some additional services or goods. Other common benefits include vocational rehabilitation, subsidized housing and food stamps. The trusts are always created as discretionary trusts, which means that money can only be paid out in the discretion of the trustee. The trustee can NEVER be the special needs person.

There are actually few rules governing Supplemental Needs Trusts (also commonly known as third-party special needs trusts). Since government benefits are available only to those with financial need, the most important rule is that the beneficiary should never be entitled to the money in the trust. If the trustee has complete discretion whether to make distributions for the beneficiary, the trust principal and income will usually not be counted as available to the beneficiary for purposes of obtaining government benefits.

The most important rule for special needs trusts is that the trust may not provide food, shelter, any asset which could be converted into food or shelter (including cash), or any items or services that are available from public benefit programs, to the beneficiary. In other words, the trust can provide for physical therapy, medical treatment, education, entertainment, travel, companionship, clothing, furniture and furnishings (such as a television or computer), and some utilities (like cable television and a telephone, but not electricity, gas or water). Distributions of cash to the special needs person outright are almost never permitted.

There are dozens of different ways to draft a Supplemental Needs Trust. In addition, the administration of a special needs trust can be extremely difficult. A seasoned lawyer, familiar with public benefits programs and special needs trust provisions, should always be involved in preparation of a third-party special needs trust. While many legal matters can be undertaken without a lawyer, or with a lawyer with general background, special needs trusts are complicated enough to require the services of a specialized practitioner.

Sometimes a person may be entitled to public benefits, but he or she has too many assets to qualify for those benefits. This is common for people like accident victims or disabled children who inherit money. In such cases, it is often possible and advisable to place assets into a special needs trust to gain, regain or continue eligibility for government benefits. Because the person is using their own money to fund the trust, there are numerous restrictions regarding how the money can be used.

Self-settled special needs trusts are much more complicated than their third-party equivalents. Usually (but not always), a self-settled special needs trust must comply with a federal law first enacted in 1993. That law requires that most self-settled special needs trusts actually be established by a judge, a court-appointed guardian or the parents or grandparents of the beneficiary (Social Security regulations may limit creation of trusts to the first two categories in most circumstances). In addition most self-settled special needs trusts will have to include a provision repaying state Medicaid agencies for any benefits, payable upon the death of the beneficiary.

In summary, Special Needs Trusts and Supplemental Needs Trusts are both Discretionary Trusts. A Special Needs Trust is established using funds of Special Needs Person. A Supplemental is established using funds of someone other than Special Needs Person. A Special Needs Trust requires that the government be paid back for Medicaid liens upon death of the Special Needs Person There is no government payback upon the death of Special Needs Person in a Supplemental Needs Trust.

Special Needs Trusts and/or Supplemental Needs Trusts are all part of a larger strategy to make sure a special needs person's financial and personal needs are met. For individuals who cannot afford these types of trusts, many charities, like Plan NJ, do have pooled funds to which you can contribute. These pooled funds offer you less control, but it does provide for a means of taking care of your loved one.

Tuesday, December 1, 2009

Special Needs Planning in NJ - Part 3 of 4


In Part III of this Series, I want to discuss estate planning issues for parents of a special needs child.

A typical estate plan for parents without a special needs child includes:
  1. Will;
  2. Financial Power Of Attorney;
  3. Health Care Power of Attorney;
  4. Advanced Health Care Directive; and
  5. Naming Beneficiaries of Retirement Plans.
The parent of a special needs child must also do everything possible to avoid giving money outright to the Special Needs Child. This includes arranging for care and financial resources for the Special Needs Child.

In order to do everything possible to avoid giving money outright to the Special Needs Child, there are certain steps that can be taken:

1) Setting up a special trust for the Special Needs Child that will not be counted against the child's income for purposes of eligibility for government programs;
2) Redoing beneficiary designation notices on life insurance contracts and retirement plans; and
3) Telling family members to either leave money to a special needs trust for the child or specifically exclude the Special Needs Child from their Wills.

There are also specific arrangements that need to be made to ensure that your special needs child is cared for after your passing. This includes:

1) Arranging for a guardian to be named for the Special Needs Child;
2) Arranging for government services (SSI, SSDI, Medicaid, etc.); and
3) Arranging for living arrangements for the child.

Parents of special needs children always have a lot to deal with, but much of this planning should be done shortly after you find out that you have a child with special needs. Most importantly, life insurance planning should be done as soon as possible. If you wait too long, you may no longer qualify for insurance - and special needs parents, more than most, need to guarantee that money will be there after they pass.