Tax Considerations

Sometimes families don’t realize that the decisions they make when thinking about their estate plans can have major tax consequences for themselves and for their heirs. When making estate planning decisions, families must consider four different types of taxes: the estate tax, gift tax, income tax, and capital gains tax.

Estate Tax

The estate tax (sometimes called the inheritance tax) and gift tax are actually tied together, and they are of minimal importance to the vast majority of middle class families. As of 2022, the exemption for both the estate tax and the gift tax is about $12 million. That means a person would have to either give away during his or her lifetime, or pass on as an inheritance at death, property valued over $12 million before either the estate tax or the gift tax would become an issue. This is an important but often misunderstood point. Many potential clients we meet at first think their goal is “avoiding estate taxes,” when they actually have no reason at all to be concerned about the estate tax because of the size of their estates.

Many people also mistakenly believe they can gift only $16,000 per person per year before having to pay gift taxes. That misunderstanding comes from the fact that the IRS has a reporting requirement for gifts over a certain limit to help it keep track of transactions made by individuals who may one day have to pay estate taxes. But this $16,000 limit is only a reporting requirement. There is no tax due on gifts over the reporting requirement until the person making gifts has used up his or her entire $12 million lifetime gift tax exemption.

Gift Tax

The gift tax reporting limit matters to individuals with very large estates because every dollar used towards the lifetime gift tax exemption also reduces the $12 million lifetime estate tax exemption. This means that individuals who make reportable gifts during their lifetimes use up their lifetime gift tax exemption and their lifetime estate tax exemption at the same time. Families expecting to have estates large enough to implicate estate tax concerns usually do not want to use up any of their estate tax exemption with lifetime gifts, so they are careful to keep any gifts below the current gift tax reporting limit. In this way, they can move assets as lifetime gifts into their children’s hands without reducing the amount they could pass on at death without paying estate taxes.

Families whose estates will be nowhere near the $12 million range at which estate taxes could be due really have very little reason to worry about the gift tax reporting limit. For families in this situation, a reportable gift of $100,000, for example, would not be taxable because it is well below the $12 million lifetime gift tax exemption. That gift would simply reduce the lifetime estate tax exemption from $12 million to $11.9 million, which is no big deal to most families.

Income Tax

Income taxes are only relevant in only one limited area of estate planning: dealing with IRAs, 401(k) funds, and other retirement accounts consisting of tax-qualified dollars. As noted above, gifts never create income tax issues, nor would an inheritance belong on someone’s income tax return. But when a person inherits a tax-qualified account, like an IRA, income tax considerations become important because the money they will receive has never been taxed. In many cases, it is possible to pass on an IRA without creating an immediate tax problem for your heirs, but only if your death beneficiary designations are set up appropriately.

Capital Gains Tax

Ironically, the capital gains tax is often the last tax on anyone’s mind when they engage in estate planning, but it should be the first for families with assets that could have appreciated in value over time, like real estate and stocks.

Generally, the capital gains tax is the tax due upon the sale of an asset when that asset is sold for more than its “basis.” In simple terms, an asset’s “basis” is the amount for which it was purchased. For example, if a person buys a stock for $10.00, keeps it for many years, then sells it for $110.00, he would owe capital gains tax on the $100.00 profit he made on the transaction.

This is important when engaging in estate planning because a person’s estate plan offers him or her a rare opportunity to reset the tax basis on assets, which can substantially reduce or even eliminate any capital gains tax when the asset is sold.

When a person’s estate plan is written in such a way that his assets do not transfer to his or her heirs until the time of death (the definition of an “inheritance”), then those assets receive a stepped-up tax basis for capital gains purposes determined based on the value of the assets on the date of death. When a person’s plan involves transferring title to certain assets as a lifetime gift, this rule does not apply, and the recipient is forced to use the original basis of the one making the gift.

This issue comes up most regularly with clients who want to deed their home to their children while they are living, in an attempt to protect the home from Medicaid liens and other long-term care risks. Families should engage in this type of planning only after carefully considering the capital gains tax consequences of such a plan.