Render unto Caesar the things that are
Caesar's . . . But not one penny more.

Basic Taxation Facts

Estate Taxes Generally:
Estate taxes are paid by the estate of the decedent, not by the beneficiaries or heirs of the decedent.

Under the American Taxpayer Relief Act (ATRA) a filing is required for estates with combined gross assets and prior taxable gifts exceeding $5,340,000.00, in 2014 (indexed annually for inflation), with a top estate tax rate of 40%.

Personal Estate Tax Exclusion:
In 2014, under the American Taxpayer Relief Act (ATRA), the IRS allows a personal estate tax exclusion of $5,340,000.00 (indexed annually for inflation).

Marital Deduction:
The IRS allows married couples to transfer an unlimited amount between spouses upon the death of the first spouse to die estate tax free.

The Marital Deduction Trust:
The marital deduction trust allows a married couple to preserve the personal exclusion of both spouses upon the death of the second spouse to die, for a total exclusion of $10,680,000.00.

Gift Taxes Generally:
Estate taxes are paid by the donor (giver), not by the donee (recipient) of a gift.

Under the American Taxpayer Relief Act (ATRA) the gift tax rate is 40%.

Gift Tax Exclusion:
The IRS allows an annual personal gift tax exclusion to the person making a gift of $14,000.00, per individual to whom such a gift is made, with a life time gift and estate tax exclusion in 2014 of $5,340,000.00 (indexed annually for inflation).

Basic Capital Gains Formulae:
Basis = Purchase Price + Capital Improvements
Capital Gain = Fair Market Value – Basis
Taxable Capital Gain = Capital Gain – Personal Exclusion

Step Up in Basis:
Under IRC §1014(a) a beneficiary receives a step up in cost basis equal to the fair market value of the bequest or devise upon the death of the benefactor.

The step up in basis can eliminate capital gains taxes for the children who receive property upon the death of their parents. This is why inter-vivos transfers are generally a bad idea, and a major advantage to the Living Revocable Trust.

Capital Gains Tax Exemption on Sale of Personal Residence:
Individuals can exclude up to $250,000.00 ($500,000.00 for a married couple) in profit from the sale of a primary residence in which that persons has lived 2 out of the last 5 years.

Tax Advantage for Married Couple Holding Title To Their Home as Community Property Instead of as Joint Tenants

WHY SHOULD A MARRIED COUPLE HOLD TITLE TO THEIR PROPERTY AS COMMUNITY PROPERTY RATHER THAT IN JOINT TENANCY?

SHORT ANSWER:
Depending on the manner in which a couple holds title to their property, upon the death of a spouse, the IRS allows a step up in basis to the surviving spouse of the following percent of the fair market value of the property as of the date of death of the first spouse to die:
  1. Joint Tenants: a 50% step up in basis.
  2. Community Property: a 100% step up in basis.
LONG ANSWER:

Suppose that John and Mary, a married couple purchased a home in 1977, for $100,000.00

In 2014, that property is worth $1,000,000.00.

Assuming that John and Mary never made any capital improvements (or worse, made capital improvements but are not able to prove the amount invested in those capital improvements).

IF JOHN AND MARY SELL THEIR HOME THEIR TAXABLE CAPITAL GAIN IS CALCULATED AS FOLLOWS:

Fair Market Value $1,000,000.00
Basis -$100,000.00
Capital Gain
 $900,000.00
Personal Exclusion ($250,000.00 x 2) -$500,000.00
Taxable Capital Gain $400,000.00
Minimum Capital Gain Tax ($400,000.00 x .15) $60,000.00
SUPPOSE THAT JOHN DIES AND MARY DECIDES TO SELL THE HOME:

If John and Mary hold title to their property as joint tenants:

The IRS allows a 50% step up in basis to fair market value for the decedent’s half of the home, while requiring that the surviving spouse maintain their basis as of the date of the death of the decedent.

Mary’s taxable capital gain is calculated as follows:

Fair Market Value $1,000,000.00
Mary’s Basis: 50% Step up in basis,
½ of original basis (John’s half)		 $500,000.00
+$50,000.00

-$550,000.00
Capital Gain $450,000.00
Personal Exclusion ($250,000.00 x 1) -$250,000.00
Taxable Capital Gain $200,000.00
Minimum Capital Gain Tax ($200,000.00 x .15) $30,000.00

If John and Mary hold title to their property as community property:

The IRS allows a 100% step up in basis to fair market value upon the death of the deceased spouse.

Mary’s taxable capital gain is calculated as follows:

Fair Market Value $1,000,000.00
Mary’s Basis:,100% Step up in basis -$1,000,000.00
Capital Gain $0.00
Personal Exclusion ($250,000.00 x 1) -$250,000.00
Taxable Capital Gain $0.00
Minimum Capital Gain Tax ($0.00 x .15) $0.00

Clearly there can be a significant advantage for a surviving spouse in holding title to property as Community Property rather than in Joint Tenancy.

Estate Tax Consequence for a Married Couple with Assets in Excess of $5,340,000.00 UNDER THE AMERICAN TAXPAYER RELIEF ACT (ATRA)

WHAT IS THE ADVANTAGE OF A MARITAL DEDUCTION TRUST?

SHORT ANSWER:

The IRS allows an unlimited transfer of assets between spouses upon the death of a spouse free of estate tax.

However, under the American Taxpayer Relief Act (ATRA) an individual is limited to a $5,340,000.00 (indexed annually for inflation), estate tax exemption to any person or persons who are not that person’s spouse.

For a couple with assets in excess of $5,340,000.00 (indexed annually for inflation), a Marital Deduction Trust can preserve the personal estate tax exemption of both persons, for a potential estate tax savings of $5,340,000.00 (indexed annually for inflation).

LONG ANSWER:

CONSEQUENCE OF IMPROPER ESTATE PLANNING

Suppose that John and Mary, a married couple, have an estate worth $6,000,000.00.

Upon John’s death, without proper estate planning, John’s one half of the estate worth $3,000,000.00, could pass to Mary, or to his heirs and beneficiaries free of any estate tax.

Assuming that John leaves everything to Mary, Mary’s estate at that point would be $6,000,000.00.

If Mary were to die soon after John, she could pass $5,340,000.00 (indexed annually for inflation), to her heirs and beneficiaries free of any estate tax. However, $660,000.00 ($6,000,000.00 - $5,340,000.00), of her estate would be exposed to estate tax.

Mary’s estate tax on her estate would be $264,000.00 ($660,000.00 x 40%).

THE BENEFIT OF PROPER ESTATE PLANNING

Suppose that John and Mary, a married couple, have an estate worth $6,000,000.00.

Upon John’s death, by utilizing a marital deduction trust, Mary would pour $5,340,000.00, of estate assets into John’s decedent’s trust, and would hold $660,000.00, in her own survivor’s trust.

Upon Mary’s death whatever amount that remains in John’s decedent’s trust would pass to his heirs and beneficiaries free of any estate tax thanks to his preserved personal estate tax exclusion.

Likewise, whatever amount under $5,340,000.00, that remains in Mary’s survivor’s trust would pass to her heirs and beneficiaries free of any estate tax.

By utilizing the marital deduction trust, John and Mary would preserve the $264,000.00 ($660,000.00 x 40%) that otherwise would have gone to pay estate taxes for their heirs and beneficiaries.

Utilization of Gift Tax Exclusions to Make Lifetime Gifts

IT’S BETTER TO GIVE THAN TO PAY TAXES

WHAT IS THE GIFT TAX?

According to the IRS a gift is defined as: “Any transfer to an individual, either directly or indirectly, where full consideration (measured in money or money's worth) is not received in return.”

Under the American Taxpayer Relief Act (ATRA) the top estate tax, gift tax and generation skipping transfer tax is 40%.

ARE ALL GIFTS TAXED?

A Gift Tax Exclusion exists that allows an individual to make a gift of $14,000.00 to an individual without paying federal taxes on the gift. A couple can each make a gift of $14,000.00 to an individual for a total tax free gift of $28,000.00.

There is no limit on how many times the Gift Tax Exclusion can be used in any given year, so long as the gifts are made to different persons.

However, gifts made utilizing the Gift Tax Exclusion will be counted against the tax payer’s Life Time Exclusion of $5,340,000.00 (indexed annually for inflation).

LONG ANSWER:

Suppose that John and Mary’s estate is worth more than $10,680,000.00.

If John and Mary decide to make the maximum tax free gift allowable to their children, they can each give $14,000.00 to Sam and $14,000.00 to Debra, for a total of $28,000.00 to each of Sam and Debra.

John and Mary would pay no gift tax this year. However John and Mary’s lifetime federal estate tax exemption would each be reduced by $28,000.00 from $5,340,000.00 to $5,312,000.00 (for a total life time federal estate tax exemption of $10,624,000.00 rather that the full $10,680,000.00 total life time federal estate tax exemption).

John and/or Mary would have to file a gift tax return (IRS Form 709) if the gift to any one individual in any given year exceeds the $14,000.00. However, John and/or Mary could use a portion of his or her lifetime federal estate tax exemption to avoid paying the gift tax in the year of the gift.

Tax Consequences of Forgiveness of Debt

WHAT ARE THE TAX CONSEQUENCES OF DEBT FORGIVENESS?

SHORT ANSWER:

Federal tax law requires that a taxpayer report as income the amount of any debt that is canceled, unless such canceled debt is either a gift or bequest. Non-business debt that is canceled is reported on 1040, line 21. Canceled business debt, is reported on Schedule C or Schedule C-EZ (form 1040) (or on schedule F, Profit or Loss from Farming (Form 1040). If you are personally liable for a mortgage (recourse debt), and you are relieved of the mortgage when you dispose of the property, you may realize gain or loss up to the fair market value of the property. If mortgage discharge exceeds the fair market value of the property it is income from discharge of indebtedness unless it qualifies for exclusion.

Canceled debt is not included in gross income if the cancellation takes place in a bankruptcy case under the U.S. Bankruptcy Code, or if the cancellation takes place when you are insolvent.

Insolvency occurs when, and to the extent that, liabilities exceed fair market value of assets, determined immediately prior to the cancellation of debt.

Debt canceled when a person is insolvent is excluded from gross income, up to the amount by which that person is insolvent.

Long Answer:

Federal tax law requires that a taxpayer report as income the amount of any debt that is canceled, unless such canceled debt is either a gift or bequest. Non-business debt that is canceled is reported on 1040, line 21. Canceled business debt, is reported on Schedule C or Schedule C-EZ (form 1040) (or on schedule F, Profit or Loss from Farming (Form 1040).

Form 1099-C, is used to inform the taxpayer of a cancellation of debt of more than $600, by a federal Government agency, financial institution, or credit union. Form 1099-C also shows any interest canceled. Only interest that would not have been deductible must be considered income.

If you are personally liable for a mortgage (recourse debt), and you are relieved of the mortgage when you dispose of the property, you may realize gain or loss up to the fair market value of the property. If mortgage discharge exceeds the fair market value of the property it is income from discharge of indebtedness unless it qualifies for exclusion.

Canceled debt is not included in gross income if the cancellation takes place in a bankruptcy case under the U.S. Bankruptcy Code, or if the cancellation takes place when you are insolvent.

Insolvency occurs when, and to the extent that, liabilities exceed fair market value of assets, determined immediately prior to the cancellation of debt.

Debt canceled when a person is insolvent is excluded from gross income, up to the amount by which that person is insolvent.

To prevent an excessive tax benefit from the debt cancellation, such excluded amount must be used to reduce certain tax attributes, thus tax on canceled debts is in part postponed instead of being entirely forgiven.

One may choose to use all or a part of the amount of canceled debt to first reduce the basis of depreciable property before reducing the other tax attributes. Generally, the amount of canceled debt is used to reduce the tax attributes in the following order: Net operating loss, general business credit carryovers, minimum tax credit, capital losses, basis, passive activity loss and credit carryovers, and foreign tax credit.

The 2006 Internal Revenue Service Publication 17 (Catalogue Number 10311G) provides as follows:

CANCELED DEBT

Generally, if a debt you owe is canceled or forgiven, other than as a gift or bequest, you must include the canceled amount in your income. You have no income for the canceled debt if it is intended as a gift to you. A debt includes any indebtedness for which you are liable or which attaches to property you hold.

If the debt is a non-business debt, report the cancelled amount on form 1040, line 21. If it is a business debt, report the amount on Schedule C or Schedule C-EZ (form 1040) or on schedule F, Profit or Loss from Farming (Form 1040), if the debt is farm debt and you are a farmer.

Form 1099-C: If a federal Government agency, financial institution, or credit union cancels or forgives a debt you owe of $600 or more, you will receive a Form 1099-C, Cancellation of Debt. The amount of the cancelled debt is shown in box 2.

Interest included in cancelled debt. If any interest is forgiven and included in the amount of canceled debt in box 2, the amount of interest also will be shown in box 3. Whether or not you must include the interest portion of the canceled debt in your income depends on whether the interest would be deductible if you paid it.

Mortgage relief upon sale or other disposition: If you are personally liable for a mortgage (recourse debt), and you are relieved of the mortgage when you dispose of the property, you may realize gain or loss up to the fair market value of the property. To the extent the mortgage discharge exceeds the fair market value of the property it is income from discharge of indebtedness unless it qualifies for exclusion under Excluded Debt later. Report any income from discharge of indebtedness on non-business debt that does not qualify for exclusion as other income on Form 1040, line 21.

If you are not personally liable for a mortgage (non-recourse debt), and you are relieved of the mortgage when you dispose of the property (such as through foreclosure or repossession), that relief is included in the amount you realize. You may have a taxable gain if the amount you realize exceeds your adjusted basis in the property. Report any gain on non-business property as capital gain.

EXCEPTIONS

Excluded debt: Do not include a canceled debt in your gross income in the following situations. The debt is canceled in a bankruptcy case under title 11 of the U.S. Code. See Publication 908, Bankruptcy Tax Guide. The debt is canceled when you are insolvent. However, you cannot exclude any amount of canceled debt that is more than the amount by which you insolvent. See Publication 908.

EXCLUSIONS

Do not include a canceled debt in gross income if any of the following situations apply:

Bankruptcy Exclusion: The cancellation takes place in a bankruptcy case under the U.S. Bankruptcy Code. See Bankruptcy case exclusion, later.

The cancellation takes place when you are insolvent. The amount excluded is not more than the amount by which you are insolvent.

Insolvency exclusion: The cancellation takes place when you are insolvent. The amount excluded is not more than the amount by which you are insolvent.

You are insolvent when, and to the extent, your liabilities exceed the fair market value of your assets. Determine your liabilities and the fair market value of your assets immediately before the cancellation of you debt to determine whether or not you are insolvent and the amount by which you are insolvent.

Exclude from your gross income debt canceled when you are insolvent, but only up to the amount by which you are insolvent. However, you must use the amount excluded to reduce certain tax attributes, as explained later under Reduction of Tax Attributes.

REDUCTION OF TAX ATTRIBUTES

If a debtor excludes canceled debt from income because it is canceled in a bankruptcy case or during insolvency, he or she must use the excluded amount to reduce certain “tax attributes.”

Tax Attributes: Tax attributes include the basis of certain assets and the losses and credits listed next. By reducing these tax attributes, tax on canceled debts is in part postponed instead of being entirely forgiven. This prevents an excessive tax benefit from the debt cancellation.

Order of reduction: Generally, use the amount of canceled debt to reduce the tax attributes in the order listed below. However, you may choose to use all or a part of the amount of canceled debt to first reduce the basis of depreciable property before reducing the other tax attributes. This choice is discussed later.

Net operating loss.
General business credit carryovers.
Minimum tax credit.
Capital losses.
Basis.
Passive activity loss and credit carryovers.
Foreign tax credit.

The Capital Gains Tax Disadvantages of Placing Children on Title in Order to Avoid Probate

The recipients of an inter vivos gift (a gift made by a living donor) retain the donor's basis in the property, for calculating capital gain.

The recipients of a decedent's estate receive a step up in the basis in the property, for calculating capital gain, to fair market value as of the date of death of the donor.

Basic Capital Gains Formulae:
Basis = Purchase Price + Capital Improvements
Capital Gain = Fair Market Value – Basis
Taxable Capital Gain = Capital Gain – Personal Exclusion

Step Up in Basis:

Under IRC §1014(a) a beneficiary receives a step up in cost basis equal to the fair market value of the bequest or devise upon the death of the benefactor.

The step up in basis can eliminate capital gains taxes for the children who receive property upon the death of their parents. This is why inter-vivos transfers are generally a bad idea.

LONG ANSWER:

Suppose that John and Mary, a married couple purchased a home in 1977, for $100,000.00

In 2014, that property is worth $1,000,000.00.

Assuming that John and Mary never made any capital improvements (or worse, made capital improvements but are not able to prove the amount invested in those capital improvements).

RESULT OF TRANSFER BY INTER VIVOS GIFT:

In 2013 John and Mary transferred the property to Sam and Debra in order to spare them the expense and agony of probate.

However, because this was an inter vivos transfer, Sam and Debra have the same cost basis in the property as their parents had ($100,000.00)

Sam and Debra sell the property upon the death of their parents. Sam and Debra would receive the following after paying the capital gains tax:

Fair Market Value $1,000,000.00 $1,000,000.00
Sam and Debra’s Cost Basis: John and Mary’s Original Basis (No step up in basis) -$100,000.00
Capital Gain $900,000.00
Personal Exclusion ($250,000.00 x 1) -$0.00
Taxable Capital Gain $900,000.00
Minimum Capital Gain Tax ($0.00 x .15) -$135,000.00
Distribution to Sam and Debra $865,000.00

RESULT OF TRANSFER BY LIVING REVOCABLE TRUST:

Fair Market Value $1,000,000.00 $1,000,000.00
Sam and Debra’s Cost Basis:,Transfer on death (100% step up in basis) -$1,000,000.00
Capital Gain $0.00
Personal Exclusion ($250,000.00 x 1) -$0.00
Taxable Capital Gain $0.00
Minimum Capital Gain Tax ($0.00 x .15) -$0.00
Distribution to Sam and Debra $1,000,000.00
Amount of Capital Gains Tax Avoided $135,000.00

Clearly Sam and Debra would benefit from the tax advantages of a distribution on death of John and Mary.

Furthermore, John and Mary are secure in the knowledge that they are in control of their property.