Advisor Today > > April 2001: Managing Money: Beware the Estate Tax Time Bomb

Managing Money: Beware the Estate Tax Time Bomb

Elimination may greatly increase capital gains taxes on some assets

Janet Arrowood

The federal government is proposing sweeping tax changes, including changes to the death tax. Although these death tax changes may eliminate estate taxes at the federal level, they may increase other taxes.

Under the present death tax structure, most estates owe no federal or state death taxes. Simple estate planning enables most couples to exclude the first $2 million1 of assets from federal death taxes2. However, eliminating the federal estate taxes may greatly increase capital gains taxes on a number of assetsÑa "tax time bomb" in the making.

The assets that would be most affected are:

Non-retirement assets (excluding non-qualified deferred annuities)
Real property (including personal/vacation residences, land and rental properties)
Businesses and farms/ranches

Currently, appreciated assets such as those listed above receive a "step-up" in basis at death, avoiding capital gains taxes of 8-20 percent on "long-term" holdings. A personal residence that has been owner-occupied for at least two of the past five years can be sold, and up to $250,000 in capital gains is tax-free.

This creates interesting scenarios if estate taxes are eliminated. The heirs, who probably don't have the deceased's records of original purchase price and additional purchases or improvements, may have a zero basis in highly appreciated assets.

Instead of excluding up to $1 million of assets per person from death taxes and taking advantage of the step-up in basis to avoid most capital gains, all assets would potentially become subject to capital gains taxes. Lower- and middle-income heirs, rather than the wealthy, would pay taxes they never owed before.

Consider these scenarios:

Martha and John each have $500,000 in non-retirement investments. They are joint tenants with rights of survivorship (JTWOS) in a house that has increased in value by $400,000. Martha dies. Since there is no step-up in basis for her mutual funds, the investments will be subject to 18-20 percent in capital gains taxes on the undeclared or deferred gains when sold. Step-up in basis does not apply, so John receives only $250,000 in tax-free gains on the house, should he decide to sell it. Now John owns all the investments and 100 percent of the house. When he sells, he will have to pay capital gains on all but $250,000 of the gain on the house and all the deferred gains on the investments. If he dies still owning the house, his investments and Martha's investments, his heirs will eventually owe capital gains on everything (unless they can document the original basis in each asset). Under current death tax laws, with some simple trusts, their estates might have avoided all capiital gains taxes and estate taxes. Instead, the total tax bill will be hundreds of thousands of dollars, and the house and/or investments might have to be sold under unfavorable conditions, further reducing the money realized by the heirs.

Matt and Kathy each have small pensions and Social Security to fund their retirement. They inherited a few blue chip stocks. At the time, the stocks were worth $15,000, but today the market value is $75,000. They own rental properties that generate additional retirement income. They paid $20,000 for each unit, put $10,000 of improvements into each unit, and the units are currently worth about $150,000 each5. Assuming that the surviving spouse does not want (or cannot afford) to keep the rentals and/or stocks, and sells in the year of the first spouse's death, the tax bill could be quite high. If there are no records of value of the stock or the original purchase price of the rentals the taxes could be significant. Under the current tax laws, little or no tax would be due when either dies, even without estate tax planning. Under the proposed changes, their heirs could owe taxes on the full value of the rentals, plus the full value of the stock, as well as ordinary income tax on the depreciation amounts for the rentals. If the heirs sold these assets today, the capital gains could be 20 percent of $300,000 ($60,000 from the stock, $120,000 from each rental) plus ordinary income tax on the depreciated amounts. If there are no records, the assets could be taxed at up to 20 percent (plus recaptured depreciation).

At first glance, eliminating estate taxes may work, but only until the assets are sold. At that time, a very large tax bill may be due, especially if the original basis cannot be established. This could easily result in the demise of many small businesses and farms.

Note that all examples, tax rates and numbers are purely illustrative and are not intended to represent any actual client situations.

In 2006.
Since state death taxes vary from zero upwards, specific state issues are not discussed herein.
The holding period to qualify as long term varies according to income level. The 8 percent rate is only available to people in the lowest current tax bracket for assets held at least five years. The 20 percent rate applies to people in the remaining tax brackets for assets held at least 18 months. There are in-between rates and longer holding periods, etc.
Note that the owner(s) must be alive at time of sale or the step-up in basis should apply. Consult a tax advisor.
This illustration does not consider the recapture of depreciation.

Janet Arrowood is a registered representative with The Leaders Group, Inc. She can be reached by email at jc_arrow@hotmail.com.

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