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Mark Cornwall: A Creative Option of the Estate Tax
Since nobody knows yet what the estate tax law will be in 2010, we might as well familiarize ourselves with a popular compromise in Congress for at least this year. By the time the dust settles over the wrangling between the House and the Senate, a creative option of the estate tax might be put into place that may or may not be the best option, determined by your sense of fairness.
There is one creative option that would change the entire system. Many professionals believe that the capital gains tax will replace the estate tax. This means the $200,000 cost basis (original payment for stocks or real estate) on your $500,000 portfolio or your residence and rental property will “carry over” to your heirs who inherit your house and not “step up” to the fair market value when you die — as is now the law.
Now, a home’s value is reappraised at death, and its cost basis is stepped up to the fair market value at the time of death when the second parent dies. If your children sell the house when you die, they pay no capital gains tax if the house has not increased in value since your death.
But according to this new capital gains plan, if it is utilized in 2010 or later, the house’s original $200,000 value will not step up in value at the surviving spouse’s death to its $500,000 present market value. What children inherit is the $200,000 cost basis. If they sell the house, they pay federal capital gains taxes on the fair market value of the house at 15 percent and state capital gains tax, which in California is 9.3 percent. This is a total of about 24 percent tax on the additional $300,000 fair market value of the house. That would be $72,000 in capital gains taxes.
In this case, the resulting tax may be inescapable using a traditional, conservative credit shelter trust and cause parents to gamble on something like a qualified personal residence trust, with which the IRS allows you to bet whether you will outlive its actuary tables. But that is another story.
A more typical story would involve your parents’ home purchased in 1956 with three bedrooms and 1½ baths for $10,000. It’s now worth $550,000. Those are very realistic numbers in Southern California even in today’s market. Assume your parents have been renting the house for profit during the past three years, and now decide to gift the house to you.
When they transfer the title to you, there will be no change in the cost basis of the house. Your parents’ cost basis of $10,000 carries over to you and, therefore, you pay no higher property tax on the property than they did. With a cost basis of $10,000, your property tax would be very low.
What happens if you want to sell the property? With a cost basis of $10,000, you would pay capital gains tax on a $540,000 gain after a sale for $550,000.
The combined capital gains tax for both federal and state of about 24 percent would leave you with a tax of $132,000, if you sold the house at today’s fair market value. It takes many years of property tax to add up to that number and justify the loss of the step-up value you would receive if you inherited the house upon their death according to the traditional plan.
But now they are saying this new concept for estate taxes will not allow the cost basis to step up upon your parents’ death to the fair market value. So the $132,000 in taxes becomes the new estate tax. If you apply this same formula to all of your parents’ properties, it gives you a good idea about who is going to get their inheritance hit hardest upon the death of their parents as far as estate taxes go.
It would probably be best if your parents kept the house and sold it while they were alive. They would still be liable for the capital gains taxes, but according to IRC 121, if a married couple have owned and occupied a house for two out of the past five years, they can exclude the first $500,000 of their capital gain from taxes. (It is $250,000 for a single person.)
In the scenario above, your parents could have sold the house they moved from three years ago and used their IRC 121 exemption. This would allow them a sum of $500,000 tax free, and they would pay only a capital gain on $40,000. If they then purchased another rental property, a cost basis of $500,000 would be much better than $10,000, since it would not have another 54 years to grow equity.
— No opinion herein is a “marketed opinion” and no information provided herein can be used to avoid tax penalties for which the taxpayer would otherwise be responsible. Mark S. Cornwall has lived in Santa Barbara for more than 30 years and practiced law here for 25 years. He is accepting new clients. His book, Estate Planning: The Heroes Way for Baby Boomers, can be purchased via his Web site, www.MarkCornwall.com; Amazon.com; or locally at Chaucer’s and Borders bookstores. To schedule an appointment, contact him at .(JavaScript must be enabled to view this email address) or 805.845.7558.
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» on 01.20.10 @ 01:43 AM
They now want your hard earded family estate—50% is what you give them now—This is above that??? to go to government—think about how much we give the over paid Gov employee’s—its never enough??
» on 01.20.10 @ 05:16 PM
Is this a done deal, losing the step-up-basis on death?
My mother chose to keep and stay in her house (been there over 50 years) for the very reason that she would have to pay a high capital gain tax on selling (and then lose her utility low income credit also) and she also knew that the children could inherit at a stepped-up basis.
This has been her main argument for staying in the house.
I need to know.
Goleta by Gosh
» on 01.20.10 @ 07:38 PM
That is the craziest idea possible. Think about it. You work and save and pay your taxes for years and years, in fact, you’re whole life. If you’re lucky (I mean if you work hard enough because nothing seems lucky) you get your hands on a couple pieces of property and now they want the equity you waited for for twenty years too. The idea of having only the cost basis to give to your children is a punishment, not an award for playing the game straight up.
» on 01.21.10 @ 09:07 AM
Goleta by Gosh asks: “Is this a done deal?”
Answer, yes. This the the tax reform adopted in the early 2000’s which eliminated the “Estate Tax” for the year 2010. Mark Cornwall wrote in December 2009 about how confusing this is going to be in 2010. He’s right.
Government does nothing well wrote: “...50% is what you give them now…” Well not quite, since there would be no 50% now. The so-called Estate Tax has expired; but returns in 2011 in a slightly different form.
Cornwall was right then when he said there will be confusion all around.
» on 01.21.10 @ 11:06 AM
I wouldn’t go so far as to say it was a “done deal.” It is a deal that many in Washington are promoting, if only in the short run. Remember that the Bill to repeal the repeal of the estate tax in 2010 was passed by the House before Christmas. Now the Senate must negotiate its deal with the House. When that is going to be done is anyone’s guess, thus the feelings of irresponsibilty. But if a new deal is not completed soon, the prospect of removing the “step up” at death, and the “cost basis” as inheritance, could be forced into law by default on an interim basis. But not yet. It’s a bad deal no matter how you look at it.
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