Pundits expect some kind of estate tax will be enacted retroactively for this year, but in case it isn’t advisors need to be prepared with other options.
Before the estate tax disappeared, assets passed to heirs benefited from a step-up in basis, which essentially eliminated any capital gains liability. However this year, until some estate tax legislation is put in place, there are limits on how much property gets a step-up in basis.
It’s complicated, but basically under the current no-estate-tax law there is an allowance for passing assets without a basis carry-over of $1.3 million for each estate. In addition there’s a $3 million step-up in basis for assets passed to a surviving spouse.
“The big scam of it all was that Bush substituted a higher capital gains tax for the estate tax,” in 2010, said Martin Shenkman, an estate planner in Paramus, N.J. “This is the stuff that no one’s talked about. … Most people are hiding their heads in the sand. That’s not acceptable because it violates the prudent investor act, which requires you to make decisions about taxes. You have to present the options to clients and document that.”
This problem doesn’t just affect the wealthy, according to David Handler, a partner at the law firm Kirkland and Ellis in Chicago. Ninety-nine percent of the country doesn’t have an estate worth more than $3 million, so they wouldn’t have paid estate taxes last year anyway, but most people do have assets — heirlooms, homes or inherited stock —that have appreciated in value and thus have embedded capital gains liability.
So this year, what can you do for clients that are trying to manage low-basis assets more than estate taxes?
Until this year, the way to minimize estate taxes was commonly to divide estate assets in half and put each half in a credit shelter trust, so the lifetime estate tax exclusion would be preserved regardless of which spouse died first. But clients didn’t have to worry about capital gains because the cost basis (what the assets were purchased at) was “stepped up” to current market value.
Shenkman said clients now must divide assets based on appreciation to minimize capital gains. The idea would be to appropriate the least appreciated assets to the spouse who’s expected to die first.
But since it isn't clear which assets will appreciate most over the year, or which spouse will die first, Shenkman suggested a simple solution: Re-title nontirement assets as tenants in common. This way whichever spouse dies first automatically holds an equal half the assets.
It’s a simple, but wholly workable solution, he said.
There are other strategies that the ultra-wealthy use on a regular basis to defer capital gains taxes indefinitely regardless of the estate tax, Shenkman said. For example, if a client owned a shopping mall that was built for a $1 million and is now valued at $2 million. Instead of selling it, the heirs could swap the property through a tax-deferred exchange for another real estate investment.
Another vehicle is an exchange fund. For example, if an heir inherit $1 million in Apple stock that was bought for $100,000, they could take that stock to Goldman Sachs and ask to put it in an exchange fund or investment partnership along with other owners of highly appreciated stock. If this is done correctly, there is no capital gains realized for the investment and the stock is instantly diversified.
Then of course, wealthy clients can also use a charitable remainder trust to essentially eliminate capital gains. The client can contribute appreciated stock to a charity, which can sell the stock to create a diversified portfolio that would throw off a steady income to the donor. Upon the client’s death, what remains in the trust would go to the charity.
“You can defer capitals gains tax for a very long time, and that can be worth a lot,” Shenkman said. “The whole concept of basis carry-over is so utterly complicated, I wonder who will ever be able to do it, and folks with megabucks will find a way around it.