In the last decade, a lot has changed with tax planning for your estate. Most notably, the estate tax exemption.
What Is Estate Tax?
According to the IRS, the Estate Tax is a tax on your right to transfer property at your death. It consists of an accounting of everything you own or have certain interests in at the date of death.
The includible property may consist of cash and securities, real estate, insurance, trusts, annuities, business interests and other assets.
Estate Tax Exemptions
In 2011, the estate tax law set a large estate tax exemption amount.
- The exemption was increased from $5 million to $10 million for estates of decedent’s dying in 2018 through 2025
- This exemption increases annually for inflation
As a result, the estate tax exemption amount is $11,700,000 in 2021 up from $11,580,000 in 2020.
Revisiting Estate Tax Strategies for Estate Plans
Now, since many estates won’t be subject to estate tax (thanks to that large exemption amount), planning for estates can be focused on saving income taxes.
While saving both income and transfer taxes has always been a goal of estate planning, it was more difficult to succeed at both when the estate and gift tax exemption level was much lower.
Below are some tax planning strategies you may want to revisit considering the large exemption amount and other recent changes in the law.
Gifts Using the Annual Gift Tax Exclusion
Estate Tax Strategy
A benefit of using the gift tax annual exclusion to make transfers during life is to save estate tax. This is because both the transferred assets and any post-transfer appreciation generated by those assets are removed from the donor’s estate.
What to Revisit
Since the estate tax exemption amount is so large, estate tax savings may no longer be an issue.
Instead, income taxes become the concern. The donation is taxed based on the difference between current value and the original value when the donor acquired it.
When you make an annual exclusion transfer of appreciated property, it carries a potential income tax cost because the donee receives the donor’s basis upon transfer.
Thus, the donee could face an income tax cost, via a capital gains tax liability, on the possible sale of the gifted property in the future. This is because the cost basis is the original value or purchase price of an asset or investment for tax purposes.
If there is no concern that an estate will be subject to estate tax, even if the gifted property grows in value, then the decision to make a gift should be based on factors other than estate tax savings.
Gift Tax Example
For example, gifts may be made to help a family member with making a purchase or starting a business. But a donor should not gift appreciated property because of the capital gain that could be realized on a future sale of the property by the donee.
If the appreciated property is held until the donor’s death, the heir will get a step-up in basis that will wipe out the capital gain tax on any pre-death appreciation in the value of the property.
Estate Plans that Equalize Spouses’ Estates
Estate Tax Strategy
In the past, spouses often undertook complicated strategies to equalize their estates so that each could take advantage of the estate tax exemption amount. Generally, a two-trust (a credit shelter trust and marital trust) plan was established to minimize estate tax.
What to Revisit
Since 2010, portability enables the estate plan to apply the decedent’s unused exclusion amount to the surviving spouse’s transfers during life and at death.
If the election is made, portability allows the surviving spouse to apply the unused portion of a decedent’s applicable exclusion amount, the deceased spousal unused exclusion (DSUE), as calculated in the year of the decedent’s death.
The portability election gives married couples more flexibility in deciding how to use their exclusion amounts.
Estate Tax Exclusion Portability Example
If a spouse dies in 2021, when the estate tax exclusion amount is $11,700,000, without having used any exclusion amount over the course of the deceased spouse’s life, the surviving spouse would be able to apply the DSUE amount of $11,700,000 to any taxable transfers made.
If the surviving spouse were to die later in 2021, then the surviving spouse will be able to use an exclusion amount of $23,400,000 (both the DSUE and the surviving spouse’s exclusion amount).
However, if the surviving spouse dies in a later year, the DSUE amount remains fixed at $11,700,000, but the surviving spouse’s basic estate exclusion amount will increase annually.
Estate Exclusion or Valuation Discounts without Preserving Step-up in Basis
What to Revisit
Some tax strategies are designed avoid inclusion of property in the estate to avoid estate tax. It may be better to have the property be included in the estate or not qualify for valuation discounts so that the property receives a step-up in basis.
Special Use Valuation
The special use valuation is the valuation of qualified real property used for farming purposes or in a trade or business based on the property’s actual use, rather than on its highest and best use.
This strategy may not save enough, or any, estate tax to justify giving up the step-up in basis that would otherwise occur for the property.
Another strategy in question is transferring property to avoid estate inclusion by limiting the transferor’s power or control over the property. Now, with the higher exemption, estates may benefit from that inclusion. It would mean a step-up in basis, which could save potential future capital gain tax.
The gap between the transfer tax rate and the capital gains tax rate has narrowed, making strategies that do not preserve the step-up in basis less desirable.
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