"Death" of Estate Tax in 2010 creates Tax Trap for Spouses

My prior post was about the federal tax impact for single individuals who die in 2010 (unless Congress does as they have promised and create an estate tax retroactive to January 1, 2010 – we will have to wait and see if that happens and how it is constructed).

The news for single folks was not good. Mom dying with a $3.5 million estate in 2009 could leave it to son tax free. Mom dying with that same $3.5 million dollar estate, assuming the basis of her assets is $350,000, now creates a  federal capital gains tax of $277,500 for son (or $416,250 if he is in NJ).

The news for married folks is worse. In 2009 mom could leave $100 million (or whatever amount) to dad with no taxes whatsoever – there is an unlimited marital deduction from estate taxes (so long as your spouse is a US citizen). In 2010 only $4,300,000 will pass tax free to the surviving spouse.

The "death" of the estate tax creates a capital gains "trap" - and the “trap" catches assets passing to a surviving spouse that were never subject to tax under the estate tax.

What??? you say. How is it possible that by eliminating the estate tax you are creating a tax for widows and widowers? As I noted, due to the magic of Internal Revenue Code Section 1014, capital gains taxes disappear at death under the 2009 law. Section 1014 creates a “step-up in basis” by stating that when an estate is subject to estate taxes, the cost basis of inherited assets is the date of death value.  For example, mom bought stock for $10, and when she dies it is worth $100.  Dad  inherits stock and sells for $100.  His capital gains is $0 ($100 of value - $100 of basis =0).

However, in 2010 there will be no estate tax, and therefore no “step-up in basis”.  Instead, per Section 1022, Dad can apply $1,300,000 million plus $3,000,000 to add basis to the assets that mom has. How might this work? Let’s say mom has a $6 million estate, made up mostly of the family business she and dad still work in and some real estate. Assume mom has a $500,000 basis in the assets – all that appreciation has been due to increases in value over the years. If mom died in 2009, dad would get $6 million tax free. If mom dies in 2010, and dad sells everything since he doesn’t want to work without his life partner, he only has a basis of $4,800,000  ($500,000 of mom’s basis + $4,300,000 of allocated basis). Since he sold for $6 million, he has $1,200,000 of capital gains. He will owe the federal government $180,000, and if he lives in New Jersey, he will also owe the Garden State $90,000, for a total of $270,000. Remember, had mom died in 2009 when there was an estate tax in place, dad would have owed $0.

It bears repeating that all other concerns aside, this new tax regime where you need to track cost basis over a life time is a nightmare. How do you prove mom’s basis before she died was $500,000? Was every improvement tracked? What documentation will the IRS accept as proof? Will you have that documentation 30, 40, 50 years later?

My next post will address some planning opportunities (every cloud has a silver lining after all) that might exist in this new tax environment.

Federal Estate Tax "Death" in 2010 Creates Capital Gains Trap

Sigh ... I was really, really hoping I would not have to post about what happens to those who die in 2010 from a federal tax perspective.  However, since Congress couldn't seem to get its act together, here is the current 2010 landscape (with the caveat that Congress can act in 2010 and have a retroactive estate tax - but, we will have to see what happens when it happens).

Did you know that the "death" of the estate tax creates a capital gains "trap"?  And that "trap" catches the smaller estates, the ones that under current tax laws have no federal tax consequences on death. 

Assume you are single person with a $3.5 million estate (I will post separately about married couples).  Had you died in 2009, there would have been no federal tax consequences to your death.  If you die in 2010,  there will no federal estate taxes (same as 2009).  However, your heirs will have to pay capital gains taxes (see, there is always a catch).

What??? you say.  I thought death was tax free in 2010.  It is estate tax free, there won't be a federal estate tax.  There will, however, be federal and state capital gains taxes for deaths in 2010. Why??? you ask.  Well, there is a pesky little section of the Internal Revenue Code (1014) that says, essentially - when an estate is subject to estate taxes, the cost basis of inherited assets is the date of death value.  For example, mom bought stock for $10, when she dies it is worth $100.  Son inherits stock and sells for $100.  His capital gains is $0 ($100 of value - $100 of basis =0).  Section 1014 is a neat magic trick - it makes capital gains taxes disappear.  In tax parlance we call this a "step-up in basis".

However, in 2010 there will be no estate tax, and therefore no step-up in basis.  Let's take the same example where mom bought stock for $10, and when she dies it is worth $100.  Son inherits stock and sells for $100.  He now has a capital gain of $90 subject to tax ($100 of value - $10 of basis = $90).  He must pay federal capital gains tax on this amount (15%) and state capital gains tax (7.5% in New Jersey) for a total tax of $20.25 if he is in NJ - or $15 if he is in FL or another state without a state estate tax.  

Notice that when mom died in 2009 with an estate tax in place, son netted $100.  However, when mom dies in 2010 with no estate tax in place, son only nets $79.75. Lets add some zeros - son nets $1,000,000 if mom dies in 2009, but only $797,500 if she dies in 2010.  Now you see how no estate tax is not necessarily a good thing?!

The above is over-simplistic, but it makes the point that the "death" of the estate tax creates a capital gains trap.

One point of "relief" - your estate will be able to allocate $1.3 million to add basis to inherited assets (different rules apply for a surviving spouse) per code Section 1022.  To continue our example, mom's entire $3.5 million estate consists of stock she bought for $10 a share and is now valued at $100 a share.  Her cost basis in her estate is $350,000.  She dies, and the estate has an additional $1.3 million of basis - so the stock now has a total basis of $1,650,000.  Son sells the stock for $3.5 million, creating a capital gain of $1,850,000, which in return has son paying a federal capital gains tax of $277,500 (or $416,250 if he is in NJ).  Remember now, if mom had died in 2009 when there was a federal estate tax, son would have paid $0 in tax.

But the the so called "relief" is a trap too - how are you going to prove basis?  How do you know what mom paid for each stock share?  And if you do know, what about splits, mergers, stock dividends - what is her cost basis in all those?  Tracking basis for assets acquired over a person's lifetime, particularly when the person is now dead, is a nightmare.

Congress has "promised" to reinstate the estate tax to January 1, 2010 - and I think we all know what weight to give to Congresses promises.

My next post will address what happens if mom dies in 2010 survived by dad  (a spouse) - and the picture isn't rosy there either.

Yes, there is a Santa Claus

Happy Holidays to you all!  

In this time of family, friends and thanks for good fortune, I like to recall a very famous letter written by 8 year old Virginia in 1897 to the to the New York Sun asking "Is There a Santa Claus?" for her father had told her that if it was printed in the New York Sun it must be true.

The editor,  Francis Pharcellus Church, created a response that 100 years later still embraces the magic of children, joy, and hope for the future.  My favorite part:

Yes, Virginia, there is a Santa Claus. He exists as certainly as love and generosity and devotion exist, and you know that they abound and give to your life its highest beauty and joy. Alas! how dreary would be the world if there were no Santa Claus! It would be as dreary as if there were no Virginias. There would be no childlike faith then, no poetry, no romance to make tolerable this existence. We should have no enjoyment, except in sense and sight. The external light with which childhood fills the world would be extinguished.

I wish you the joy of seeing all the Santa Clauses who abound in your life this holiday season.

- Deirdre

 

Image: Salvatore Vuono / FreeDigitalPhotos.net

More Tax Provisions than the Estate Tax Expiring December 31

Interior US Capitol Building Derek Jensen of Jensen Law Offices reminds us in his blog that the Estate Tax is not the only federal tax provision expiring on December 31 due to Congressional inaction this year.

The estate tax isn't the only tax provision expiring on Dec. 31. Due to congressional inaction 50 tax provisions will expire. Including the annual AMT patch, the deduction for state and local sales taxes, the $4,000 deduction for college tuition, a provision that allows taxpayers age 70-and-a-half or older to transfer up to $100,000 directly from an IRA to charity, the business R&D credit, and a biodiesel tax credit. Many of these provisions require action every year and they are likely to be extended again, but retroactively this year.

As a tax professional I find in mindboggling that Congress, whose constitutional mandate (Article 1, Section 7)is to make and pass tax laws "All bills for raising revenue shall originate in the House of Representatives; but the Senate may propose or concur with amendments as on other Bills" can't bring themselves to do their jobs.  

I know there is a lot going on in Washington, but these tax provisions all have a 1 year life, and Congress knows that they therefore must act on them every year.  It is not as if the tax code is a small deal - it is only the means by which the federal government makes the money they spend.  It is lazy to say "we'll do it next year and make it retroactive" because what if you don't?  How can a person or business plan how to allocate their dollars when the tax laws that share in those dollars are in limbo?  How can a business plan to invest in new research when they can't budget what it will cost them because they don't know if the Research and Development credits will exist? Why should 23 million more American's have to worry if the AMT may catch them this year (or just be surprised by it) because our elected representatives can't get around to passing the annual patch that resets the income levels?

All of us are working harder, doing more to meet our responsibilities - Congress should be held responsible to to make the time to meet their responsibilities and this nonchalance about doing their jobs should not be ignored (like they are doing to the tax code). 
 

 

Estate Tax - Repeal and Retroactive Reinstatement Now Seem Likely

 I had previously reported that a one-year extension of the federal estate tax seemed likely in an end of year defense spending bill.  Now, Hani Sarji reports that it is likely Congress won't act this year, but will act next year and reinstate the estate tax to January 1, 2010 in some form.

In Estate Tax Fix Fails, Repeal Likely - US Lawmaker (Dow Jones Newswires, 12/15/09), Martin Vaughan reported the following:

Rep. Earl Pomeroy (D., N.D.), said plans to include a temporary estate tax extension in end-of-year defense spending legislation have been dropped because of Senate opposition.

As a result, he told Dow Jones Newswires, the estate tax will be repealed on Jan. 1 as foreseen by current law, and replaced with an onerous capital gains tax that heirs would have to pay when they sold any inherited assets. . . .

It is regrettable that we're going to have this disruptive period without a permanent resolution," Pomeroy said.

But he said "the prospects are 100%" that Congress will come back next year and reinstate the tax, and make it retroactive to Jan. 1, 2010.

My issue with repeal and retroactive reinstatement is what happens to the person who dies before the reinstated law is passed?  From a planning perspective, I know Congress won't leave well enough alone, and the reinstated law will not be identical to the current law, which means that for the person who dies during the gap time will have lost an opportunity to fully plan their estate.  See a prior post on my other thoughts on retroactive estate tax reinstatement.

Image: Salvatore Vuono / FreeDigitalPhotos.net

Tax Deduction for Dependent Pets?

I love animals - I have 2 large and happy labs, and have had a host of cats, dogs, fish, rabbits, guinea pigs and mice over the years.  My dogs are truly family members and I am not sure they don't think they are children with furry coats.

Apparently U.S. Rep. Thaddeus McCotter, R-Mich., also loves pets, because he has sponsored the The Humanity and Pets Partnered through the Years (HAPPY) Act, which would permit an income tax deduction of up to $3500 a year.  Seriously - this legislation is being put before Congress.  As an opinion piece from the Press of Atlantic City points out "With 62 percent of American homes owning a pet, that bill could cost a lot of tax money at a time when the federal government can least afford it."

A pet owner who can't care for his or her pet is heartbreaking - the op-ed piece shares the story of an elderly couple who had to turn in their German Shepherd for adoption because they couldn't care for him.

Unfortunately our tax woes go beyond our pets. It saddens me that congressmen waste their time issuing legislation that has no chance of going anywhere instead of looking at the real fact that our government spends more money then it takes in.  As in small business owner will tell you, that is a recipe for disaster. 

So Congress, get real and spend your time on legislation that addresses the fact that the elderly couple above couldn't afford to feed themselves, much less their dogs.

And for you pet lovers out there like me, take a page from the Atlantic City Press and donate pet food to a local food bank - Fido, Fifi and their owners will thank you (woof).

Image: freedigitalphotos.net

Estate Tax Update - One Year Extension Seems Likely

Even though the House passed a measure for a permanent extension of the estate tax at a $3.5 million dollar exemption per person, sources are reporting that the Senate is looking to push through a one-year extension by year end.  This would mean that the estate tax exemption would be $3.5 million per person in 2010, but still come back at a $1 million exemption in 2011.

Elder Law Answers reports that "Congressional watchers are coalescing around the prediction that the Senate will likely pass a one-year extension of the estate tax before year's end -- probably as part of a defense spending bill."  It cites in in-depth discussion at OMB Watch why the Senate won't likely move for a permanent resolution in the way of the House.  OMB Watch notes "The other option is for the Democratic leadership to tack a one-year estate tax extension onto a likely omnibus appropriations bill that insiders say Congress will pass before the end of 2009."

CNN Money concurs with the one year extension, advising "The Senate is likely to rally around a short-term fix and pass a one-year extension of the tax at 2009 levels by Dec. 31."  Hani Sarji at his blog reports that the House is now even expecting a one year patch, their recent legislation notwithstanding "'According to House Majority Leader Steny Hoyer, estate state tax fix may be temporary and may be attached to defense spending bill".

Why all this pressure?  Well, besides the financial incentive in certain circles for mom and dad not to survive 2010 intact, a permanent change to a $3.5 million exemption would actually add to the deficit.  CNN Money clarifies this point:

The House bill would increase the deficit by $234 billion over 10 years, according to the Joint Committee on Taxation. That's because even though current law would repeal the tax for one year, it reinstates it by 2011 at an exemption level of just $1 million, which would mean an increasing number of estates would be subject to the tax as years went by."

 $234,000,000,000.00 - That is a lot of zeros to be giving up at a time the government is broke.  So expect a push for the real question of estate tax reform, not a patch, into 2010.

 Photo courtesy Francesco Mariano

Charitable Deduction from an Estate?

A great answer to a frequently asked question when handling a loved ones estate was recently posted by taxgirl.com.

Here is the situation - Grandma wanted to give $10,000 to the ASPCA.  She told everyone in the family, but didn't put it in her Will. Can the deduction for a charitable contribution still be made?

Like all good questions - the answer is yes and no (isn't the law great?).  Taxgirl summarizes the issues nicely:

Here’s the unhappy rule: if a charitable donation is not specifically authorized in a will or trust, the estate may not properly take a deduction for the donation. <snip>

However, there is some light at the end of the tunnel. Individuals may properly donate items which pass to them from an estate and claim a charitable deduction on their personal return. 

So what to do.  Well, you could take $10,000 from your share of the estate and donate it to charity. Grandma's wishes would be honored, and you would be able to take the deduction on your personal tax return. If there are 4 beneficiaries, each could donate $2500 in her honor.

What if the item to be donated isn't cash, but stuff?  For example, donating all of Grandma's furniture and household items to charity? In that case the best idea is to value the property (have a personal property appraiser come in), distribute the property to the beneficiaries, and then the beneficiaries can take the charitable deduction on their tax returns.  Note that there is not a requirement that the beneficiaries physically take ownership of the property - the property could be transferred to the beneficiaries via an assignment and then all the personal property picked up by the charity at the house.

Could an Illness Wipe You Out? Bankuptcy Might Need to be Planned For

http://www.freedigitalphotos.net/images/view_photog.php?photogid=721 Christine Wilton has an insightful post "Are We Just One Injury or Illness Away From Bankruptcy?"  In it, she highlights the issue of what happens if you get ill, become disabled, and the insurance just isn't there.  If there bills are enough to completely wipe you out, what should you do?

This is particularly relevant to the retired.  This past week I got 2 separate inquiries about someone who either (1) did not sign up for Medicare at 65, or (2) didn't get a Medigap policy, all based on affordability issues.  They got sick, and now want coverage, but the coverage isn't there.  Both situations were not life threatening, but could wipe out the finances they had to provide for the rest of their lives.

First, what not to do.  Christine cautions against using credit cards or drawing down a home equity line to pay your medical bills.

If you're faced with medical debt, do not use your credit cards or home equity or any other financing to pay that debt. You're only adding interest to that debt and avoiding the most likely inevitable bankruptcy. What's worse is that if you use home equity, you could lose your home later if you fall behind on your mortgage."

Some things to do:

  1. Read your medical coverage and understand its limitations.  
  2. Use pre-tax dollars when possible to pay for care (at a 25% tax rate, this mean for every $100 you are spending the government is essentially kicking in $25 because you don't have to use the $25 for taxes).
  3. Try to settle your debt - the head in the sand approach won't make it go away.
  4. Speak to a qualified bankruptcy attorney to determine if that might be your best option, as well as all the drawbacks of going that route.

 Image courtesy of: http://www.freedigitalphotos.net/images/view_photog.php?photogid=721

IRS 2010 Mileage Rates Going Down

The IRS has announced that the mileage deductions are going down in 2010.  You may recall they were raised in response to the gas crises of recent years when we were hitting $4 a gallon - now that we are back in the $2 range, the deduction rate is going down:

The new rates effective 1/1/10 are:

Business  - $0.50 (down from $0.55)

Medical/Moving - $0.165 (down from $0.24)

Charitable - remains the same at $0.14

Interesting however that while gas price levels are definitely off their peak, Bloomberg.com reports:

The national unleaded average gasoline price rose to $2.633 per gallon yesterday, according to AAA. The cost of gasoline is 83 cents a gallon higher than at the same time last year.

Don't forget that if your employer does not reimburse you for mileage, and you itemize, you might be able to deduct mileage on your 1040.

 

10 Facts from the IRS - Extended First-Time Homebuyer Credit

Ok - so my thoughts that enough was enough on the first time home buyers credit clearly did not sway Washington.  The credit has been extended, but due to all the fraud, the IRS wants clear limitations to be known - so here they are:

1. You must buy – or enter into a binding contract to buy a principal residence – on or before April 30, 2010.

2. If you enter into a binding contract by April 30, 2010 you must close on the home on or before June 30, 2010.

3. For qualifying purchases in 2010, you will have the option of claiming the credit on either your 2009 or 2010 return.

4. A long-time resident of the same home can now qualify for a reduced credit. You can qualify for the credit if you’ve lived in the same principal residence for any five-consecutive year period during the eight-year period that ended on the date the new home is purchased and the settlement date is after November 6, 2009. (This might be helpful for children looking to purchase an elderly parents home for a promissory note as part of asset protection planning).

5. The maximum credit for long-time residents is $6,500. However, married individuals filing separately are limited to $3,250.

6. People with higher incomes can now qualify for the credit. The new law raises the income limits for homes purchased after November 6, 2009. The full credit is available to taxpayers with modified adjusted gross incomes up to $125,000, or $225,000 for joint filers.

7. The IRS will issue a December 2009 revision of Form 5405 to claim this credit. The December 2009 form must be used for homes purchased after November 6, 2009 – whether the credit is claimed for 2008 or for 2009 – and for all home purchases that are claimed on 2009 returns.

8. No credit is available if the purchase price of the home exceeds $800,000.

9. The purchaser must be at least 18 years old on the date of purchase. For a married couple, only one spouse must meet this age requirement.

10. A dependent is not eligible to claim the credit.