By: Matthew M. Shafae, Attorney
Litherland, Kennedy & Associates, APC, Attorneys at Law
The “T-word” usually makes our eyes glaze over and we picture an overworked accountant wearing a green eyeshade crunching a bunch of numbers for us every April. Well, unfortunately, I can’t make them go away, but I can attempt to explain how taxes may impact your estate planning.
Within the context of your estate plan, there are typically three main taxes that are relevant: the estate tax, the income tax, and, sometimes, property tax. It’s important not to confuse these taxes for one another in order to keep your estate planning goals crystal clear. We’ve all heard of these taxes, but what exactly are they for, and why do we have to pay them?
The estate tax is sometimes called an inheritance tax or a death tax. Those are all different names referring to the same tax. It is imposed by the federal government on all taxpayers in every state. In addition to the federal tax, some states impose their own state inheritance tax. (In California, there is NO state inheritance tax, so only the federal estate tax applies). The estate tax is a transfer tax. A transfer tax is imposed on you whenever you transfer your property to another person or entity. Transfers can mean a gift made during your life (birthdays, graduation, holidays) or a gift made after you die (through a will or trust, for example). For a quick discussion on taxes on gifts made during your life, see our previous blog post on gift taxes.
As current law is written, the estate tax only applies to somebody who dies owning more than $5.45 million. That is because each taxpayer currently receives an exemption for $5.45 million worth of property, and that exemption amount increases every year with the rate of inflation. So, that means you are exempt from owing this tax if your estate, when you die, is valued less than the exemption amount. For married couples, you can combine your exemption amount with your spouse’s exemption amount. Practically speaking, married couples have a combined exemption amount of $10.9 million. As you can imagine, most people’s estates won’t be subject to this tax. However, for those lucky few, the maximum estate tax rate is a hefty 40% on estates in excess of the exemption amount. You can use estate and tax planning techniques to minimize your exposure to the estate tax.
The income tax is the tax imposed on your taxable income each year. Taxable income is what we all declare every April on tax day. This tax is imposed by the federal government, and an additional income tax is imposed by most states. There is a state income tax in California, but for purposes of this post, we are only focusing on federal income tax. There are several ways to earn income: you can exchange your time and effort for compensation (working a job for a wage, for example), or you can buy or receive property, wait for it to increase in value, and then sell it for a profit. Let’s focus on that second one.
The tax that applies to something you sell after it increased in value from when you got it is called the capital gains tax. That increase in value is recognized as income by the federal government, and the government would like a share of that profit. For most of us, a rate of 15% applies to that type of gain, and for some in the top tax bracket, a 20% rate applies.
When somebody dies and passes property on to another person, that property usually gets what is called a “step up” in basis. For example, if you receive a piece of real estate as an inheritance, and you turn around and sell it, you only pay the gains you recognized based on the value of the property on the day that person who gave it to you passed away, not the day that that person purchased the property. For a brief discussion on the step up in basis, refer to our previous blog post. This step up in basis would not occur if that same person gifted that real estate to you while she was alive. The timing and method of your gifts may significantly impact your future beneficiaries’ income tax bill. Proper estate planning techniques allow you to pass property on to your children and loved ones without sticking them with an unexpectedly huge income tax bill. Remember, this is separate and distinct from any estate tax exposure.
Property taxes are imposed on people who own real estate. Unlike the estate tax and income tax, it is not imposed by the federal government, but rather by your county tax collector. In California, the amount is based on the assessed value of your property, and that value gets reassessed at very distinct moments in time. Usually, the reassessment occurs when there has been a change in ownership. That could be through a sale, or if someone gifts all or a portion of property to someone else. There are exclusions that may apply to the change in ownership that allow the new owner to use the same assessed value as the old owner. A commonly used exclusion is the parent-child exclusion. Using this exclusion, a parent may convey an unlimited value of property to her child without a reassessment of the value of the property. Similarly, a child may convey property to a parent with the same exclusion. Much like we discussed how proper planning may help to avoid any unexpected negative income tax implications, proper planning may be used to avoid unnecessary reassessments of property and minimize unnecessary property tax exposure. Again, this tax is levied on property owners, and is not linked to the imposition of estate tax or income tax.
Probate fees are fees ordered by the court for the representative of an estate to pay in the county where a probate case is filed. They are NOT a tax imposed by a taxing authority. So when you hear about avoiding probate because of the fees, or the costs and fees associated with probate, do not necessarily think of a tax. The three taxes described above are distinct and separate from probate fees.
Now that you have a basic foundation in the main three taxes (and probate costs and fees) that come in to play with your estate planning, we can schedule a time to discuss your specific situation further.
- Reasons an Estate Plan Could Be Challenged: Part 1 – Formal Requirements - January 24, 2020
- Estate Tax Exemption Amounts to Increase - November 6, 2019
- Beneficiary Designations, etc., Aren’t a True Substitute for a Trust - March 6, 2019