3 Tax Issues to Consider in Estate Planning
When planning for the distribution of assets after your death, it’s important to understand the income, property, and estate tax consequences of decisions about who inherits, how, and when. Here, we introduce these tax considerations with the intention of delving deeper into each tax issue in future articles.
Income Tax
It may seem odd that estate planning decisions may affect future income tax liability. After all, income taxes are levied on salary, gains on investments, and business profits – income generated during your lifetime. So how does income tax factor into decisions about death? Income tax liability could change depending on whether you give away assets during your lifetime or at your death, how you take title to property, and what type of trust is funded upon your death.
For instance, capital gains tax (a form of income tax) is applied to the difference between the amount paid for an asset (e.g., a rental property) and the amount for which it is sold. The amount paid for a property is your cost basis. Upon your death, that property receives a “step-up” or “step-down” in cost basis, meaning that its cost basis is adjusted to the fair market value at the time of your death. If your beneficiaries decide to sell the property the day after you pass, they pay little to no income tax since the amount for which it is sold is also the fair market value. By contrast, if that property is given away during your lifetime, the beneficiary’s cost basis is the same as your cost basis – i.e., the beneficiary receives a carryover basis. When the beneficiary sells the property, she will likely face a significant capital gains tax. The savings on income tax may make you think twice about when to give away your assets – during your lifetime or upon your death.
In another article, we will discuss how the beneficiaries you choose for retirement accounts like 401(k)s and IRAs may also affect income tax consequences.
Property Tax
Property taxes are another important consideration in estate planning, especially in California where property is expensive and appreciates rapidly. Property taxes in California are based on the assessed value of real property, which generally reflects the property’s market value at the time of purchase. California’s property taxes are governed by Proposition 13, a ballot initiative that caps the annual increase in assessed value at 2% or the rate of inflation, whichever is lower, unless there is a change in ownership. A change in ownership results in a property tax reassessment … unless an exemption applies.
Since estate planning often involves the change in ownership of property, a transfer can easily and unintentionally result in an increase in property taxes. Estate planning decisions often turn on whether the transfer qualifies for an exemption. After all, with California’s highly appreciating home prices, can the beneficiary of a gifted property afford the resulting increase in property taxes?
Further, recent legislation drastically changed property taxes on transfers between parents and their children. In the past, such transfers qualified for an exemption from reassessment. However, Proposition 19, effective February 16, 2021, significantly narrowed the exemption such that many children inheriting properties can no longer afford to keep the property if it comes with a property tax reassessment.
Proper estate planning may reduce or eliminate any increase in property taxes.
Estate Tax
Estate tax, also known as the “death tax,” is the federal tax levied on a decedent’s estate upon his or her death. If the value of the decedent’s estate exceeds the estate tax exemption, his estate will owe an estate tax equal to 40% of any amount above the exemption. These taxes can significantly reduce the amount of wealth passed on to heirs and can affect how families approach their estate plan.
Estate planning decisions are often made with the goal of minimizing estate tax liability. Individuals can employ various strategies, such as funding irrevocable trusts, making annual gifts to beneficiaries, and utilizing marital deduction and charitable giving provisions. However, these strategies often come at a cost – the loss of control over the assets used to fund the irrevocable trusts or assets that were gifted.
The estate tax exemption is ever changing, whether due to a new administration occupying the White House or the annual exemption indexing for inflation. It’s hard to predict the estate tax that will befall your estate. For those who pass in 2024, the estate tax exemption is $13.61 million. Bear in mind that current law has the estate tax exemption dropping to about $7 million in 2026. At a rate of 40% of anything above the exemption, careful estate planning decisions need to be made to minimize the estate tax before 2026.
Conclusion
Estate planning involves more than just choosing beneficiaries. It requires a comprehensive understanding of the various tax implications that can affect the distribution of assets. Income, property, and estate taxes all play significant roles in shaping the outcome of an estate plan.
Through careful planning and consideration of tax implications, individuals can protect their wealth and provide for their loved ones long after they’re gone. Stay tuned for future articles that will dive deeper into each type of tax – income, property and estate – and how each can affect your estate plan.
Tiffany K. Chiu is a Partner at Modern Wealth Law, APLC. Tiffany is a skilled bilingual (Mandarin and English) estate planning attorney who caters to the needs of individuals, families, and small business owners in Orange County. She has extensive experience in drafting documents related to formation, financing, reorganization, conversion, and dissolution of joint ventures, partnerships, limited liability companies, and corporations.
