7 Simple Ways to Minimize the Pennsylvania Inheritance Tax

It's been a little while since I have written an article on the Pennsylvania inheritance tax.  However, before I discuss ways to minimize the PA inheritance tax, it is important to understand that the tax rate is affected by who receives money upon your death.

As a refresher, Pennsylvania has an inheritance tax on most assets that are transferred at the time of your death if they are going to anyone besides a spouse or a charity.  There is also no inheritance tax if a child under age 21 dies and leaves their estate to their parent or step-parent.

Pennsylvania Inheritance Tax on Assets Passing to your Children, Grandchildren, Parents and Grandparents

• There is a flat 4.5% inheritance tax on most assets that pass down to your children, grandchildren, great-grand children or your other descendants.
• There is a flat 4.5% inheritance tax on most assets that pass up to your parents, grandparents or your other lineal ascendants. (Exception if the decedent is under age 21.)
• Pennsylvania treats a son-in-law or daughter-in-law as if they are a child for purposes of the inheritance tax.  As a result, there is a flat 4.5% PA inheritance tax on assets that pass to the wife or widow and husband or widower of the decedent's child. 

Pennsylvania Inheritance Tax on Assets Passing to your Brothers, Sisters, Nieces, Nephews, Friends and Others

• There is a flat 12% inheritance tax on most assets that pass to a sibling (brother or sister).  
• There is a flat 15% inheritance tax on most assets that pass up to nieces, nephews, friends and other beneficiaries. (This means there will be 15% tax on money you leave to your dog, cat or horse.)

7 Simple Ways to Minimize the Pennsylvania Inheritance Tax

1. Set up joint accounts with the people you wish to benefit.  Pennsylvania will only tax the percentage of assets owned by the decedent, not the full amount.  
• This is a particularly useful strategy if you have one child that you trust completely as only one-half of the jointly owned assets will be taxed.  However, if you have more than one child, it is possible that you and all the children are joint owners of the account, so if you have three children, only 1/4 of the account will be subject to the PA inheritance tax.
• If you have more than one child, be careful of setting up a joint account with just one person (because you may accidentally cut your other children out)
• Be sure that you don't have any concerns that your child will take your money and it won't be available for you to use.
• Transfers must occur more than one year before death to achieve the maximum tax benefit.
2. Gift your assets to your children.  This can be a very dangerous strategy, so I strongly recommend consulting with a tax attorney or accountant before making the gift.
• Dangers include giving away an asset that has a low basis resulting in a capital gains tax which could be far more expensive than simply paying the PA inheritance tax.
• If you give away too much, you could be subject to federal gift taxes or generation skipping transfer taxes.
• This could potentially cause problems if you wish to qualify for Medicaid.
3. Buy extra life insurance.  Life insurance is not subject to the Pennsylvania inheritance tax, so converting non-life insurance assets to life insurance will reduce the tax.
• An interesting planning opportunity is to by a long term care insurance policy that has a life insurance rider.  This way if you don't use up the LTC policy, it can pass tax free to your heirs.  
4. Utilize life insurance to give money to beneficiaries who are taxed at the highest tax rates.  So let's say you have total assets of $1.1 million dollars including a life insurance policy worth $100,000, and you want to leave $100,000 to your nieces and nephews and you want to leave the rest of your estate to your children.  
• If you have name your nieces and nephews the beneficiary of the life insurance and give the rest of your assets to your children, there will be a total PA inheritance tax of $45,000 (4.5% x $1M).  
• If you give the children the life insurance money, and have a will leaving your nieces and nephews $100,000 from your Will with the rest to the children, the total PA inheritance tax will be $55,500 (15% x $100,000 + 4.5% x $900,000). 
5. Buy real estate outside of Pennsylvania.  OK, maybe this isn't very simple, but Pennsylvania only taxes assets located in Pennsylvania, so a shore property in New Jersey will pass free of the PA inheritance tax.
• Beware of taxes in other states
• Don't put the real estate in an entity such as an LLC - Pennsylvania reserves the right to tax an interest in business.  (The legal theory is that you no longer own real estate, but the LLC, which is subject to a PA inheritance tax.)
6. Pay the PA inheritance tax early.  If you pay the Pennsylvania inheritance tax within 3 months from date of death, you are entitled to a 5% discount.
7. Convert your IRA to a Roth IRA.  The conversion will come at a cost to your current non-retirement assets, thereby reducing your PA taxable estate for inheritance tax purposes.
• This strategy works best when you have enough funds outside your retirement account to pay for the income taxes on the conversion.
• This strategy is especially valuable if your children are high income earners, this way they can receive distributions from the ROTH, after your death, free of income tax.
• I strongly recommend consulting with a tax attorney or accountant though before doing the conversion.  

Other Not-So-Simple Ways to Minimize the PA Inheritance Tax

1. Move to another state.  Again, this may not be simple for many people, but if you already have a property in another jurisdiction, consider whether you should change your domicile for tax purposes.  (Obviously you must actually meet the requirements of changing your domicile.)
2. Invest in farmland or a family business.  Pennsylvania exempts certain farmland and small businesses from the inheritance tax.  The problem with this may be getting your money back out of the business.
3. Setting up a GRAT or GRUT (setting up a special type of trust that creates an annuity back to you and gives excess investments to your heirs).
4. Setting up a CLAT or CLUT (setting up a special type of trust that creates an annuity to charity and leaves the rest to your heirs).
5. Setting up a CRAT or CRUT (setting up a special type of trust that creates an annuity to your heirs and leaves the rest to charity).
6. Setting up a spousal access trust.  These are typically over-funded life insurance trusts.  Money can be used for your spouse and children while your alive and then it goes completely tax free to your children.  This is a fantastic way to minimize the federal estate tax as well as minimizing the PA inheritance tax.

Simple is Never Simple

As always, be very careful that any changes you make to beneficiary designations or joint ownership of accounts could dramatically alter your overall plan.  So it never hurts to run what might seem like a simple change by an estate planning attorney.

New Jersey Estate Tax - Permanent Repeal?

As many of you know, the new Democratic Governor of New Jersey, Phil Murphy, was engaged in a recent budget showdown with members of his own party.  A last minute government shutdown was avoided, however, as the legislature and the Governor came to terms on a variety of tax increases and spending priorities.  For more specifics, NJ.com has a good article here.

From the perspective of estate planning attorneys, what is noteworthy is that there was never any mention of bringing the New Jersey estate tax back.  One of the concerns with many lawyers was whether, with a new Governor, the estate tax repeal would be lifted.  This does not appear to be the case any time soon, so it looks as if we should continue to plan as if New Jersey will not have a state estate tax, at least for the time being.

Remember, New Jersey still does have an inheritance tax though.

As a reminder, this permanent change means people who have older Wills and Trusts should bring them in for a review.  It is possible that the tax formulas are outdated and that there are new planning opportunities to simply your documents or minimize capital gains taxes upon your death.

NJ Estate Tax Repeal: How Does This Affect You?

It's official.  According to NJ.com, Governor Christopher Christie has signed a a bill to repeal the New Jersey Estate Tax.  The new law is part of a larger package deal that increases the gas tax, reduces the sales tax slightly, gives the working poor a larger tax credit, gives a tax cut on retirement income and gives a tax exemption for veterans who have been honorably discharged.

Under prior New Jersey law, a person may leave an unlimited amount to a spouse or charity. However, any money going to anyone else above $675,000 (the "exemption amount") is subject to an estate tax. This rule will remain in effect for the rest of 2016.  

For calendar year 2017, the estate tax exemption amount for NJ will increase to $2,000,000.  The tax rate will generally start at about 7.2% and go up to 16% on estates over $10,000,000.

There will be a full repeal of the NJ Estate Tax starting January 1, 2018.  

We have confirmed that New Jersey will NOT be repealing its inheritance tax. Accordingly, money that is left to a non-class A beneficiary will still be subject to a tax.  In other words, there will still be a tax if you leave money to anyone other than a spouse, your descendants, your ancestors or a charity upon your death.

So the big question for many might be how does this affect you.  I will break this down into 5 categories:

1) People who have prepared existing estate planning documents;
2) People with assets between $675,000 to $5,450,000 (for individuals) and married couples with assets less than $10,900,000;
3) Married couples with assets in excess of $10,900,000; 
4) Snowbirds; 
5) Widows and widowers who are the beneficiary of a credit shelter trust; and
6) People who wish to consider Medicaid planning.

1) For people who have already prepared their estate plans, most likely this will not adversely affect your plans.  However, the modification of the tax law likely gives you the opportunity to simplify your documents.  In particular, it is common practice in New Jersey to create a trust for a surviving spouse (often referred to as a Family Trust, Bypass Trust, Credit Shelter Trust or A-B Trust) to double the $675,000 exemption among spouses.  

There still may be other reasons to have a trust for a surviving spouse (such as in second marriage situations), but starting 2018, doubling the NJ exemption amount will no longer be necessary.

2) For New Jersey domiciliaries who have assets above $675,000 (the NJ estate tax exemption limit in 2016) and below the federal estate tax exemption limit ($5,450,000 for individuals and $10,900,000 for married couples in 2016), it was a common part of estate planning for a person to make deathbed gifts to minimize the NJ estate tax liability.  Once the NJ estate tax gets repealed, it will generally be much more beneficial for a person to keep all of their assets until their death rather making substantial gifts during lifetime.

Until 2018, deathbed gifting can be very tax efficient because New Jersey has an estate tax but it does not have a gift tax.  Accordingly, there is the opportunity to substantially minimize the estate tax.  The problem however, is that many people make the mistake of gifting substantially appreciated assets such as stock or real estate. You often want to keep appreciated assets until death to obtain a step-up in basis.   

So before you make a gift, you would need to weigh the potential NJ estate tax consequence of keeping an asset versus the potential capital gains tax if an asset is sold after the gift is made.

Now with the repeal of the NJ estate tax, unless a person is likely to die prior to 2018, you don't need to worry about making the calculation as to whether the NJ estate tax or the capital gains tax will be higher.  It will almost always be better to keep the asset.

3) For married couples with assets in excess of the federal estate tax exemption amount, I have read a number of studies that indicate that a couple can usually transfer wealth in a more tax efficient manner by establishing a credit shelter trust for the surviving spouse rather than relying on portability.  

There are few reasons why wealthier clients may want to continue to use traditional credit shelter trust planning.  The first is that while the estate tax exemption is portable, the generation skipping transfer tax (GST Tax) is NOT portable to a surviving spouse.  Many wealthy clients often wish to make sure the money goes not just to their children, but also to more remote descendants.

Another benefit to traditional credit shelter trust planning is that it acts as freeze for the assets inside the trust.  Specifically, let's assume that we have a married couple with exactly $10,900,000.  If we put half of those assets in trust on the first to die, then regardless of how much that goes up or down, it passes tax free on the surviving spouse's death.  So if the value of the trust goes up at faster rate than the inflation adjustment on the exemption amount, the beneficiaries are basically saving about $0.23 on the dollar because the estate tax is a 40% tax and the capital gains on the appreciation is only taxed at 23%.

While none of this planning will be different after the NJ Estate gets repealed compared to now, it makes the planning much easier to justify because right now we have a dilemma as to "HOW MUCH" we fund the credit shelter trust with.  To avoid any tax on the first to die, a credit shelter trust can only be funded with $675,000.  For some, this hardly makes it worth setting up. However, as the estate tax in NJ goes away, we no longer have this concern.

4) For snowbirds and other people who wish to avoid a "death tax", very simply, starting 2018 the tax incentive to move will be dramatically reduced.  Back in 2009, I wrote a post discussing the tax benefit of relocating to Florida.  Once the NJ estate tax gets repealed, for many it will make little difference from a tax perspective where their domicile is.

That being said, there are still significant differences between being domiciled in New Jersey vs. Florida.  After all, if you own real estate in both places, you still will need to pay property tax in both locations.  The biggest differences that people should be aware of are:

• Florida does not have a state income tax, whereas NJ does.  (Note NJ will start exempting a substantial portion of retirement income from the state income tax); 
• Florida property has homestead protection only if you are a domiciliary of Florida.  This can provide asset protection and it usually stops the property tax from increasing; and
• NJ is keeping its inheritance tax.  So if you plan to leave your assets to nieces, nephews, friends or other non-class A beneficiaries, there could be a substantial tax savings upon your death.

5) If you have a husband or wife who passed away leaving money to you in trust, come 2018 it may be beneficial to consider options for terminating the trust.  Imagine a scenario where husband dies in in 2004 leaving $675,000 in a credit shelter trust (often called a Family Trust or Bypass Trust) for his surviving spouse.  It is likely that these assets in trust have appreciated to over $1,000,000.  If these assets stay in trust until the surviving spouse's death, it will not receive another step-up in basis.  However, if the trust is terminated and assets are distributed to the surviving spouse after 2018, it could be very beneficial from a tax perspective.  

There are many caveats to this plan.  First, you would not want to terminate the trust if the first spouse to die wanted to protect the money in trust for his/her surviving children - so you would not want to terminate the trust in second marriage situations.  Second, you may not want to terminate the trust if the surviving spouse has substantial assets or debts.  It may also not be beneficial to terminate a trust if the value of the trust assets have gone down in value.  

Nevertheless, it would be advisable to consider terminating a trust to make life easier for the surviving spouse and avoid the hassle of having to file an extra income tax return for the trust. 

Please note that a trust can only be terminated if the trust allows it, so you should have the trust looked at to see if the document allows the trust to be terminated.  If the trust does not allow for termination, consider whether it should be modified under the New Jersey Uniform Trust Act.

6) While I don't do Medicaid planning, I do engage in tax planning, and tax planning just got much easier.  The problem with Medicaid planning is that there is so much bad information out in the public sphere.  

I frequently get clients with millions of dollars who want to do Medicaid planning.  They don't realize that to do this type of planning, they actually need to give away most of their assets.  This might work well with someone who has a few hundred thousand dollars.  However, the more money you have, the less sense it usually makes to do this type of planning.

For example, if you have a $500,000 IRA, stock with a basis of $100,000 and worth $400,000, and a house with a basis of $50,000 and now worth $600,000, let's talk about the tax impact of most Medicaid planning.  In order to "give away" everything to qualify for Medicaid (a total of $1.5M here), the person would have to withdraw their entire IRA, causing a federal and state income tax of over $175,000.  Additionally, the transfer of the stock and real estate now would be subject to a built in capital gains of $850,000, resulting in about another $175,000 in capital gains taxes when sold.  

All told, this planning will likely cause about $350,000 in taxes.  This does not even factor in the planning fees and the loss of opportunity to grow the IRA in a tax deferred form.  At $10,000/month in a nursing home, that is about 3 years in a nursing home.  According to the non-profit Life Happens, the average stay in a nursing home is almost 2 and half years and about 70% of the population winds up spending some time in a nursing home.  A $350,000 tax could have paid for 3 years of nursing care home... and in a non-Medicaid facility.  

Prior to the change in the estate tax law, an argument could be made that the increase in income taxes was somewhat offset by a decrease in estate taxes. Until the end of 2016, with an estate of $1.5 million, there was the potential estate tax of over $60,000.  Repeal of the estate tax obviously changes the equation.  Under the new tax law, it is generally more prudent to keep assets in your name rather than giving them away ahead of time.  So while Medicaid planning can certainly be appropriate for some, the larger your estate, the less financial sense it makes to engage in this type of planning.  

Non Residents of Pennsylvania Can Be Subject to Pennsylvania Inheritance Tax

I frequently get calls from individuals who had a relative pass away with property located in Pennsylvania. Even though the decedent lived somewhere besides Pennsylvania, you should be aware that Pennsylvania reserves the right to tax this property on the death of the owner via an inheritance tax.

This tax will apply whether the decedent owned the property outright or in a revocable trust. Moreover, it does not matter where the beneficiaries live.  However, the tax rate for the PA inheritance tax is based upon who receives the property.  So, there will not be a tax if the property is left to a surviving spouse or a charity, but there will be a 4.5% tax if it is left to children.

There are ways to minimize or avoid this tax completely, but often it can come at the cost of paying more in capital gains tax.  If you are a non-resident owner of Pennsylvania real estate, I strongly suggest you meet with an estate planning attorney on how to minimize the taxes on your death.

Gifting to Parents to Save on Capital Gains Taxes

As I gaze outside at yet another major snowstorm here in Mercer County, NJ and contemplate how nice it would be if I were visiting my folks near my Boca Raton, Florida office, I am reminded of a tax savings idea that I heard was gaining traction amongst wealthy children whose parents are still living.

With the federal estate tax exemption up to $5,340,000 after its most recent adjustment for inflation, children that own highly appreciated assets (such as stock or real estate) can simply gift these assets to their parents now. When the parent passes away, the children can receive these assets back with a stepped up basis, potentially saving hundred of thousands of dollars in capital gains taxes when the assets are finally sold.

While at first blush this seems like an incredibly easy strategy to save money on taxes, there are actually many pitfalls. In particular, the strategy will not work well if:
1) the parent is receiving Medicaid or government benefits;
2) the parent lives in a state or jurisdiction that has a state estate tax or inheritance tax;
3) the parent has remarried; 
4) the parent has significant wealth and has their own estate tax problems; or
5) MOST IMPORTANTLY, the gift must be made to the parents at least one year prior to the parent's death to avoid triggering Section 1014(e) of the Internal Revenue Code.*

Additionally, there could be problems if you have siblings or step siblings as the child who originally owned the assets would obviously want to ensure their return. Here is the final catch, the IRS will not like it if you prearrange this plan. In other words, the parent can't immediately promise/guarantee that they will redirect the asset to the child.

Finally, gifts of certain assets will require an appraisal for the federal gift tax return that would be required (Form 709), potentially making this a costly transaction.

Please contact our attorneys if you would like to learn more about this type of gift planning or any other estate planning.

*Updated on 5/22/14 to reflect the need to make the gift at least one year prior to parent's death.

A Trust can Qualify for a Section 121 Deduction (For Sale of a Personal Residence)

Typically, people take it for granted that there will not be any tax when they sell their personal residence.  Technically, there is a tax, but the government also offers a limited exclusion under Section 121 of the Internal Revenue Code.

For individuals who sell their primary residence, you can exclude the first $250,000 of gain.  After that, it is subject to a capital gains tax.  For married couples, you can exclude the first $500,000 of gain.

In order to qualify for the exclusion, you must have OWNED and USED the residence as your principal residence for 2 of the last 5 years ending with the date of sale (it does not have to be consecutively). If the home was previously used as a rental property, in a business or for another non-qualified use, there may be longer holding requirements or a reduced exemption amount.

One common estate planning tool that many attorneys create is a revocable living trust.  A revocable living trust, also known as just a Living Trust, is device to manage a person’s assets during life and after death. While the Grantor is alive, the Grantor can manage his or her trust funds as the Grantor wishes. When the Grantor passes, it acts like a Will but with the added benefit of avoiding probate.  If a person sets up a revocable trust, it is highly recommended to transfer all real estate into this trust, including the primary residence.

Another common estate planning tool, particularly for individuals doing Medicaid planning or VA benefit planning, is to move the primary house to an irrevocable trust, which is set up as an intentionally defective grantor trust (IDGT).  An IDGT is a type of trust that is outside a Grantor’s estate for estate tax purposes while simultaneously requiring the Grantor to be taxed on the income earned in the Trust.

Under Internal Revenue Code Treasury Regulation 1.121-1(c)(3)(i), if a residence is owned by a trust, for the period that a taxpayer is treated under sections 671 through 679 (relating to the treatment of grantors and others as substantial owners) as the owner of the trust or the portion of the trust that includes the residence, the taxpayer will be treated as owning the residence for purposes of satisfying the 2-year ownership requirement of section 121, and the sale or exchange by the trust will be treated as if made by the taxpayer.

So, the long winded answer to the question is, yes, if a trust owns a primary residence and it is set up correctly, it can qualify for the Capital Gains Tax Exclusion under Section 121 of the Code.

Summary of Tax Law Changes 2013 (Fiscal Cliff Deal)

As you know by know, the Congress and the President have finally agreed to a fiscal cliff deal.  While I haven't had a chance to read all 157 pages of the American Taxpayer Relief Act of 2012 yet, here is what I can gather from most major news sources:

1) The federal estate tax, gift tax and the federal generations skipping transfer (GST) tax will continue to have $5,000,000 exemptions, indexed for inflation.  The estate tax, gift tax and GST tax exemption amounts were $5,120,000 for 2012.  It will be $5,250,000 for 2013 after the most recent inflation adjustment.  The highest rate will go up from 35% to 40%.  This is a permanent change to the law.

  Note: Technically there are mulitiple rates for estates under $5,250,000.  This will not affect most people, but it can affect non-resident aliens with significant assets in the US or people who are otherwise not entitled to the full estate tax exemption.

2)  The income tax rates for 2013 are:
                              Married Filing Jointly        Single
     10% Bracket    $0 - 17,850                       $0 - 8,925
     15% Bracket    $17,850 - 72,500              $8,925 - 36,250
     25% Bracket    $72,500 - 146,400            $36,250 - 87,850
     28% Bracket    $146,400 - 233,050          $87,850 - 183,250
     33% Bracket    $233,050 - 398,350          $183,250 - 398,350
     35% Bracket    $398,350 - 450,000          $398,350 - 400,000
     39.6% Bracket $450,000 and up              $400,000 and up

    The change here was an increase in the top rate for married couples earning $450,000 or more and individuals earning $400,000.  For Head of Household, I believe it is $425,000.  The amounts here have been indexed for inflation for 2013.

3) Payroll taxes will increase to 6.2%, reverting back to the levels of 2010.

4) There will also be a phaseout of personal exemptions for individuals earning more than $250,000 and couples earning more than $300,000.  Head of Household limit is $275,000.  These appear to be indexed for inflation.

5)  Permanently indexes Alternative Minimum Tax (AMT) for inflation.

6)  Capital Gains Tax Rates for 2013 go from 15% to 20% for individuals earning $400,000 or more and couples earning $450,000 or more.  It will stay at 15% for everyone else.  (Caveat:  It is unclear to me at this stage whether the $400,000 & $450,000 threshhold refers to all earnings or simply earnings from dividends and capital gains.)

7) Extenstion for 5 years of the child tax credit and $2,500 tax credit for college tuition.

8) Extension for 1 year of the accelerated "bonus" depreciation on business investments.

9) Extension of tax free distributions from individual retirement plans for charitable purposes.

In other news, the 2503(b) annual exclusion amount was will increase from $13,000 to $14,000 as it was indexed for inflation.  This is not as part of the Fiscal Cliff deal.

---------------
Revised on January 11, 2013. Indexing brackets for inflation.

Step-Up in Basis Rule - Common Mistakes

When a person sells property, that person has to pay a tax on the gain from the sale. Gain is determined by subtracting the sales price of the object from the basis of such object. For example, if I sold a stock for $100 and the basis was $40, the gain would be $60.

The basis of an object is generally the price a person has paid for it. However, if you pay money to improve the object (such as buying an addition onto a house), the basis will increase. If you depreciate an object for tax purposes, the basis will decrease. To more on the basics of basis, see my post: Understanding Basis.

Notwithstanding the crazy rules for an individual who may have passed in 2010, Section 1014 of the Internal Revenue Code states that if a person holds property at the time of his or her death, it will receive a new basis equal to the fair market value of such property at the person's date of death. This is known as the Step-up In Basis Rule because in almost all circumstances, the fair market value of the assets owned by a decedent is greater than the basis of in the decedent's hands just before he or she died.

However, the Step-up In Basis Rule is really more accurately called the Fair-Market Value Date of Death because, especially in this economy, there is a chance that the date of death value is less than the basis just before death. So the first mistake many people make is in not selling assets before they pass on which they can take a loss. If you bought stock for $20,000 and now it is only worth $10,000, consider selling it. If you sell it before you die, you can take the tax loss, if you keep it until you die, your heirs cannot claim that tax benefit.

If you are an executor or an elder law practitioner, you should also be aware that you have the option of valuing all assets under Section 2032 alternate valuation date. The alternate valuation date is six months following the date of death. So let's say on the date of death the assets are worth $5,500,000 and six months following the date of death they are worth $5,000,000. Unless there is a state estate tax, you may be better off using the alternate valuation date so that the beneficiaries have a higher basis in the property, even if there is a small federal estate tax. On the other hand, if, six months after the date of death, the assets are worth more, you are not permitted to use the 2032 elections.*  (See 2032(c).) The second common mistake made by many is to not wait the six months and run the calculations for both scenarios.

So, if the beneficiaries of a descendant's property get to take appreciated property with a step up in basis, why don't people just transfer their property to a sick relative and then have them bequeath it back them when the sick relative dies. Well, unfortunately, this rarely works. Often times, it can result in a gift tax, inheritance tax or estate tax. Additionally, under Section 1014(e), if you receive a property by gift, you have to hold it for one year before your heirs can get the benefit of the step-up in basis rule. This is the third common mistake. When doing an estate administration, many practitioners and accountants fail to adequately track the basis of the assets.

*Updated on 5/5/14.  Thanks to Bob Derber for pointing out that I also made a common mistake!

Who exactly is a Covered Expatriate?

In 2008, President Bush signed the Heroes Earnings Assistance and Relief Tax (HEART) Act. One of the major provisions of the Heart Act was to collect substantial taxes from certain United States taxpayers (whether a citizen or a permanent resident alien) who expatriated from the United States after June 16, 2008. The individuals that this law applies to are known as "Covered Expatriates."

There can be harsh federal income tax and federal inheritance tax consequences if you are deemed to be a Covered Expatriate.

A person is considered a Covered Expatriate if he or she:
1) is a US citizen who renounced his or her citizenship OR a permanent resident alien who relinquishes his or her status after being a permanent resident alien for 8 of the last 15 years; AND
2) has had an average annual net income tax of more than $124,000 ($136,000 adjusted for inflation) in the preceding five years OR has a net worth equal to or more than $2,000,000 OR such person fails to certify, under penalty of perjury, that he or she has met the income and asset requirements.

Additionally, this statute does not apply to dual citizens who became a citizen of the United States by birth, but have never had substantial contacts with the United States. A person is considered to have substantial contact with the United States if he or she was ever a resident of the United States, ever held a passport OR was present in the United States for more than 30 days during any calendar year 10 years prior to the person giving up their United States citizenship. There is a slight variation on this rule for dual citizens who give up their US citizenship prior to age 18 and 1/2.

To learn more about who is a Covered Expatriate, wee Internal Revenue Code Section 2801 and Section 877A(g)(1).

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.

Perfect Time to do Estate Planning for that Vacation Home

Sometimes in a bad economy, opportunities present themselves. One great planning opportunity that currently makes a lot of sense is a special trust known as a QPRT (Qualified Personal Residence Trust). A QPRT is great way to pass on wealth to your heirs in a tax efficient manner and without affecting your more liquid assets.

Here's generally how it works:
1) The owner of a property places a personal residence (or vacation home) in trust. The owner can continue to live in and use the property for a set number of years. At the end of the term, the property goes to whomever the owner wants, typically the owner's child or into another trust for the benefit of the child.
2) This gift is a legally enforceable promise to make a gift of the property to the child in X years from now. So, if the house is worth $500,000, and you promise to give it to your daughter 7 years from now, it is not really a $500,000 gift due to the time/value of money. The actual amount of the gift depends upon a variety of factors including the age of the donor and the current interest rate.
3) This plan can produce large estate tax savings. Giving away property while you are alive is an estate planning tax strategy known as an estate freeze. You are giving away property now so that future growth occurs in the estate of your heirs, rather than in your own estate. A QPRT leverages this strategy so that you are combining a discounted gift with an estate freeze.

• Assume the following hypothetical. A wealthy 70 year old woman (worth $3,500,000) lives in New Jersey and has one adult son. She owns a shore home worth $1,000,000. Now, upon this woman's death, in New Jersey, she may bequeath $675,000 before having a NJ estate tax. Under current federal law, she can bequeath $3,500,000 before she has a federal estate tax. There is no limit to what she may gift away during life according to NJ, but the federal limit is $1,000,000. After that, there is a federal gift tax.
  
• This woman decides to give away her shore home, worth $1,000,000, to her daughter. She structures the transaction so that the term of the QPRT is 7 years. This results in a taxable gift for federal gift tax purposes of $657,300 based upon the woman's age, the term of the trust and the March 2009 Section 7520 rate. There is no NJ gift tax.
  
• Now, let's fast forward 7 years and 1 day, when the woman passes. I will assume the value of the shore property increased to about $1,300,000 and the rest of her estate only modestly increased from $2.5 Million to $2,700,000. If she had not given anything away, then at the time of her death her estate would have equaled $4,000,000. Assuming that the federal estate tax exemption remains at $3,500,000 and the New Jersey Estate tax exemption remains at $675,000, then her estate would have a combined estate tax liability of approximately $505,400 ($225,000 federal and $280,400 New Jersey). By making this gift via a QPRT, we completely elimiate the federal estate tax and the New Jersey estate tax would be reduced to approximately $155,600 - a savings of $349,800. (To compare with an outright gift of property, the combined estate tax would be $245,600, a savings of only $259,800.)
  

Traps to be wary of:
1) Be careful about giving away highly appreciated real estate unless you are quite sure the donees plan to keep it in the family for a long time. This is because the donees receive the gift with a carryover basis and could be subject to a very large capital gains tax upon the sale of the property.
2) Do not use this technique if the donor is in poor health. Setting up a QPRT is most effective when the donor survives the term of the trust. If the donor does not survive, then the property is included in his gross estate for both federal and state estate tax purposes.
3) For the same reason as Trap #2, it is best not to set up too long of a term. The longer the term, the greater the risk that the donor will pass. In my opinion, a term longer than 10 years usually produces a risk that outweighs the benefits of obtaining a discount on the gift. This is especially true now that the federal estate tax exemption has increased.
4) If the donor is married, it is usually best to set up two QPRTs, with the wife giving away her half in one QPRT and the husband giving away his half in the other. This technique increases the chance that at least one person will survive the term.
5) This technique works even better when there is a high interest rate, so if the owner has an estate subject to the federal estate tax, the best time to do a QPRT is when the value of the property value is low, but the AFR (applicable federal rate) is high.

In conclusion, this is still a great time to do gift planning, but you should consider doing so with assets that are not as liquid.

Note: QPRT calculations done courtesy of Adam Epstein at Bernstein Wealth Management.