Inheritance Tax and Estate Tax Laws Are Set to Hit Middle Americans Hard
“Inheritance tax” and “estate tax” are commonly used as interchangeable terms. Technically, inheritance taxes are usually state
imposed and are paid by the individual who gets property because of the death of another person.
The estate tax is what the Federal government charges on assets passed because of the death of a person. Property is valued at the date of death and then the estate tax is calculated as a percentage of that value. If you are using inheritance tax and estate tax as interchangeable terms, that’s OK, but understand there is a technical difference.
In a way it is easier to refer to property as inherited property and the tax on that property as the inheritance tax. Whatever term you use, the tax can be huge.
For the last three or four years the inheritance tax hasn’t really been on the public’s mind, because a person could die and pass a relatively large amount to his or her heirs without paying any tax. The Federal limit in 2011 to the present is over $5 million dollars. About 16 states also have some sort of state inheritance tax, but generally state inheritance tax issues are superseded by the Federal tax.
That means most Americans aren’t concerning themselves to any great degree over the inheritance tax. The $5 million amount is called the estate tax exemption. It is the amount of property that is exempt from the inheritance tax or “estate tax.”
Every Dime is Subject to the Inheritance Tax
Technically, every dime of a person’s estate is taxed with the inheritance tax or estate tax. However, the Federal Government gives everyone a credit of a specific number of dollars to offset the first dollars due under the inheritance tax laws. The “estate tax exemption equivalent” is the amount of property that generates a tax equal to the estate tax credit given by the IRS.
So, technically all the exemption property is taxed under the inheritance tax laws, but there isn’t any tax owing on it, because the credit just offsets the value of the tax generated by the exempt property.
When the estate tax exemption is $5 million, that means the average family doesn’t have to pay any Federal tax. Although, technically all of the decedent’s property is taxed, there isn’t any tax owing because the value of all the property is under the exemption limit. It is important to understand that the property is actually taxed, even though no tax is owing.
If your family isn’t worried about the inheritance tax, because the total amount of property is under the exemption equivalent, then you want all of the property to “pass” under the inheritance tax laws.
Because the property is technically taxed, it will receive a step up in basis to the value on the date of death. After all, it was taxed at that value, so it should be valued going forward at that value.
This is important, because if Dad bought the house 30 years ago for $50,000 and it is worth $400,000 today, if you sell the house there is a $350,000 gain. However, if it was taxed under the inheritance tax laws, then it got a step up in basis on the day Dad died, and when you sell the house the week after Dad dies for $400,000, then there is no gain. No income tax to pay!
That’s good, because there wasn’t any inheritance tax owing and then no income tax owing.
However, if the property came to you not because of Dad’s death, but because he put your name on the deed, then the property wasn’t subjected to the inheritance tax, and you didn’t get a step up in basis. You pay capital gains tax on the $350,000 in “profit” that results from the sale.
Inheritance Tax Disaster
The inheritance tax at $5 million is great, but if law ever returns to earlier levels and lowers the estate tax exemption amount to only $1 million, that’s going to hurt a lot of middle income Americans. AND you should be aware that every state has its own laws about state estate tax. Some match the federal limits, but some are much lower. You can be a millionaire today and still be clipping coupons to make ends meet.
Your estate includes all of your property, life insurance, retirement accounts, IRAs, personal property, everything. So, it is easy to be a millionaire for estate tax or inheritance tax purposes and still be struggling to make ends meet. To get a more detailed look at what your estate includes, read a chapter from my best selling book, Protecting Your Financial Future.
By the time you read this, the law may have changed again. So make sure you check out the latest inheritance tax laws and check specifically on the estate tax exemption equivalent.
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Estimating Your Estate Value
To help you understand the significance of this tax law change, and help you plan ahead, I’ve included an excerpt from my book, Protecting Your Financial Future.
Appendix 3 (Download Here) should be used to estimate the value of your estate. Clients often grossly underestimate the value of their estate. One widowed lady came in to me and wanted a trust. She convinced me she was really very poor, and she even talked me into a discount because she was so poor. Today, I never believe a client who pleads poverty. In her mind she was poor. In the bank’s mind she was loaded. She had over $500,000 in the bank plus all of her other assets.
An estate includes the real estate, bank accounts, stocks and bonds, cars, boats, and the personal property including diamonds, silverware, collectibles, horses, dogs, cats—no, not the kids. (The IRS figures the kids are a liability, not an asset, to you.) When clients just add up assets like these to determine what their estate is worth, they are in trouble. They are forgetting things like the life insurance policy death value and cash value; their business, and all of its inventory; the note payable by the kids; the partnership interest they have with Uncle Joe, which doesn’t give them any income, but is worth a ton of money on paper; their retirement; IRA; and the list goes on.
Of course, the debts, mortgages, and other financial liabilities you may have are subtracted from the total assets in order to arrive at a value for your taxable estate.
Inflation—Gotcha
Because values don’t stay the same, it is hard for you and me to estimate the value of things. Values usually increase due to inflation. The couple that paid $25,000 for their home in San Marino, California in 1960 may not realize that the house is worth about $2.5 million in today’s market. My neighbor built a house two years ago. In our town real estate values have been very flat for about 10 years; in fact, values have gone down. The neighbor sold the house last week. The sales sign hadn’t been up 24 hours before the “sold” sign went up. Obviously, the neighbor hadn’t realized that real estate values have gone up in our town during the past year. Someone in our town that had a nontaxable estate a year ago may now be looking at big time estate tax problems. Can you see why I recommend the full A-B trust even for people who may not technically need it today?
I also recommend funding trust B with the full exemption equivalent amount. Many trusts are written so estates worth less than twice the exemption equivalent amount are divided equally between trust A and trust B at the death of the first spouse to die. There are pros and cons to funding the trusts this way. If you fund trust B with less than a full exemption equivalent amount, you are wasting part of the tax sheltering capacity of trust B. I hate waste. It is possible to fund trust B with a full exemption equivalent and simply fund trust A with less, but the trust document has to be written to permit such a funding technique.
For example, if a full exemption equivalent amount is funded into trust B and the remainder, even though it is less than a full exemption equivalent amount is funded into trust A, then the full sheltering power of trust B is taken advantage of. Trust A can still “grow” to the full exemption equivalent amount with investments or inflation before the family faces an estate tax. Make sure you understand what options your trust gives you when trusts A and B are established.
