Want to save a bunch of money? I’ll explain how here. But I’m warning you, the discussion can get a little dense because it involves the ‘T’ word (taxes). If you understand this topic, you’ll understand the single biggest tax break available to the 99% (the rest of us).
I’ll also warn you that there are some moves afoot in Congress to change these rules. The Senate version could apply retroactively to January 1, 2021. I’ll refer to these changes by the name used in the Senate: The STEP Act. Those changes will be the subject of a separate article. First, you must understand the current rules (you may also have a chance to save some dollars this year if you know what might be going on).
If you don’t care about any of this (particularly saving some money), then skip this article because it’ll bore the heck out of you.
The Basic Facts
Edith and Ralph Flimpster have two children: Jimmy John (“Sammich”) Flimpster and Janey Ack Flimpster-Cellar (“Janiac”). Janiac has two children, who shall remain nameless.
In 1972 Edith and Ralph bought a 100 acre farm for $50,000. Other than trees and deer, there is nothing on it. It is now worth $220,000.
Basic Tax Concepts
Basis is the tax term used for whatever amount you might ‘have in’ the property. It not only involves what you paid for the property, but what you can show you have invested in the property, and some other adjustments your accountant loves to tinker with. For our purposes, though, “Basis” will simply mean whatever was paid for the property.
By the way, these rules apply to all sorts of property – we’re just using real estate here as an example.
The amount realized on the sale of property is, for our purposes, the sales price if the property is sold. Under the STEP Act most transfers, including gifts, will be treated as a “sale” at fair market value of the transferred asset.
Gain is the tax term used to describe the ‘profit’ on a sale of property (other than property held for sale in a business – inventory). And you know what usually happens to Gain? It’s called “capital gain” and it gets taxed. For most people, the federal capital gains tax rate is 15% (5.25% for North Carolina). If you’re a high-stepper with income north of $445,850 it will go up to 20% ($501,000 for a couple). Very few of my clients fall into that “high-stepper” bracket (that is my made-up term).
Edith and Ralph decide to sell the property to Billy “Slick” Buyer for $220,000. The Flimpsters came out ahead on the sale by $170,000. They’re happy. Then their accountant, Arnold Abacus, explains why they’ll owe 15% capital gains tax to the feds and 5.25% to North Carolina. The $170,000 is capital gains and the total tax tab will be $34,425. Slick’s basis in the property is what he paid for it: $220,000.
WAIT! An Exception for the Home!
Now let’s say that instead of 100 acres, trees and deer, the land is actually their residence in the suburbs of metropolitan Seagrove, North Carolina. Same numbers apply: They bought it for $50,000 and it is worth $220,000. If Edith and Ralph decide to downsize and they sell the residence for $220,000, there will be no (ZERO) capital gains. Under federal law, each individual may exclude the first $250,000 of capital gains on sale of a residence in which they have a legal interest.
This rule stays the same under the STEP Act.
Another Basic Tax Concept – Transferred Basis
Back to the nonresidential property. If instead of selling the property Edith and Ralph give the property to Sammich and Janiac, their basis will be the same as Mom’s and Dad’s. This type of basis is called “Transferred Basis.”
Three years after receiving the property (and two years after Ralph’s and Edith’s death in a tragic meteorite strike) Janiac and Sammich sell the property to Slick Buyer for $235,000. Their gain is $185,000 ($235,000 – $50,000) and their combined federal and state tax will be $37,462.50.
Going back to the exception for a residence: If Ralph and Edith give the residence to Janiac and Sammich “to protect it in case they have to go to the nursing home” they have transferred their basis to the kids and it is no longer a residence they have any legal interest in (the kids now own it). Later, everyone agrees to sell the residence so Ralph and Edith can “move into town.” The same capital gains taxes will be due from Janiac and Sammich as discussed in this Example #2.
Edith and Ralph completely blew the $250,000 (each) residential exception from capital gains. As I will discuss later, there is a MUCH better way to handle this.
Another Basic Tax Concept – Stepped-up Basis
When an individual receives property as a result of the death of someone else and the property is technically includible in that deceased person’s taxable estate for estate tax purposes, then the individual receiving the property gets a new tax basis equal to the value of the property on that deceased individual’s date of death. This is called “Stepped-up Basis.” (By the way, this year each individual gets an exemption of $11.7 MILLION for estate tax purposes – $23.4 MILLION for a couple).
Under the STEP Act, such a transfer could be taxable, even for smaller estates escaping estate taxation.
Instead of giving the property to the kids, Edith and Ralph put in their wills that upon the death of the survivor of them, Sammich and Janiac are to receive the property. Fortunately, the meteorite struck Edith and Ralph while visiting friends and not the empty property (so the property is still OK and worth $220,000). Obviously, Ralph and Edith died at the same time (the coroner couldn’t find any evidence to the contrary) and they definitely owned the property, so it is includible in their taxable estates. Fortunately, however, the property was worth only $220,000 on their deaths and that, along with their other assets, put them well under the $22,400,000 per couple limit – so at least Sammich, Janiac and Arnold Abacus don’t have to worry about estate taxes.
However, Janiac’s and Sammich’s basis in the property is $220,000. A year later they sell the property to Slick for $235,000. Their capital gain is just $15,000. Their total tax tab (federal and state) is $3,037.50.
A Planning Dilemma
Protecting residences, land and other highly appreciated assets is a very common concern for Mason Law, PC clients. Many people resolve this concern on their own by simply giving everything to the kids. As I explained above, that is an expensive mistake to make from a tax standpoint. Not to mention what happens if Janiac is convicted of a double axe murder (or simply gets divorced or sued for debts) and Sammich loses everything he owns on a local sandwich franchise.
Further, under the STEP Act the gift to the kids could be subject to immediate taxation.
A Planning Solution
So, what to do? Certain types of trusts will protect everything put into the trust while also preserving the tax advantages. In fact, there is a Treasury regulation that says that a residence put into a properly drafted trust will retain the capital gains exclusion if sold.
Under the STEP Act, these trusts would become even more important.
What is the downside to a trust? They’re complicated and you’ll need to see a professional who knows what he is doing. Of course, I can think of at least one elder law attorney who fits that profile.
The upside? Tens or hundreds of thousands of dollars in savings.
Finally . . . .
As I mentioned throughout this article. The STEP Act could wreak some havoc to the rules that are current law.
Now that you understand Tax Basis and Capital Gains Tax 101, please read my article discussing what the STEP Act could mean for you.