Estate planning error could mean huge tax bill

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Q. My parents are in retirement age. They are insisting on transferring their assets to be under my and my sibling’s name to ensure that nothing is taxed after they pass away. They have a primary home, an investment property and some cash savings accounts, all totaled under $1 million. What are the tax advantages of this versus leaving it later after their passing?
— Son

A. Wait. Stop. Tell your parents not to do anything of the sort.

These transfers have serious tax consequences, most of which will be bad.

It’s common for individuals to transfer assets to their children in their golden years for a number of reasons including Medicaid qualification, probate avoidance and estate/inheritance tax avoidance, said Gary Botwinick, an estate planning attorney and chair of the taxation/trusts and estates department at Einhorn Harris in Denville.

You’ve asked about the tax advantages, so we’re focus on that.

Until 2018, New Jersey residents were potentially subject to three taxes at death, Botwinick said: the federal estate tax, the New Jersey inheritance tax and the New Jersey estate tax.

In 2016, and for the 15 years before that, the New Jersey estate tax was imposed on transfers to children if the total estate exceeded $675,000, Botwinick said. In 2017, that amount was increased to $2 million, and starting in 2018, the New Jersey estate tax was repealed.

So you don’t have to worry about the estate tax, unless, of course, the tax is reinstituted.

Then there’s the inheritance tax, which was not repealed.

“It is only imposed upon inheritances by individuals other than `Class A’ beneficiaries. A spouse, child, grandchild and parent are all `Class A’ beneficiaries,” Botwinick said. “Thus, in your case, if you inherit these assets from your parents, there will be no New Jersey inheritance tax.

Then there’s the federal estate tax.

“You should be so lucky that you need to be concerned about federal estate taxes because they do not apply until your estate exceeds $11.18 million, and since your parents are both living, only if their estates together exceed $22.36 million,” he said. “Barring some extraordinary growth of your parents’ assets between now and their ultimate demise, there will be no federal estate tax at their deaths.”

So to your question about whether there’s any harm in making the transfers now rather than waiting for their deaths.

The harm could be significant, Botwinick said.

“You see, there is this really great benefit in the Internal Revenue Code that many individuals are completely unaware of; it is called the `stepped-up basis,'” he said. “The tax basis of any asset held until death is stepped-up to fair market value.”

This means, for example, that if your parents have owned the investment property for many years, paid significantly less than it is worth today, and the building has been completely depreciated, then their tax basis is probably significantly lower than the fair market value, he said.

If they sold it today, there would be a significant capital gains tax to be paid by them, imposed upon the difference between the sales proceeds they receive and their tax basis, Botwinick said.

If they gift the property to you during their lifetime, you will take the property with a carry-over basis, meaning that you will have the same basis they had, and will have the same capital gains tax due when you sell it, he said.

But if instead, your parents hold on to the investment property until their deaths, you will inherit the property with a stepped-up basis.

“This means that you could sell the property the next day and completely avoid any capital gains tax,” he said. “Alternatively, if you choose to hold on to the property after your parents’ death, then you could begin to depreciate the building again, thus lowering any taxes you would pay on any rental income.”

The same rules hold true for their primary residence, he said.

“So in your efforts to save estate/inheritance taxes that wouldn’t be due anyway, you would wind up shooting yourself in the foot for income tax purposes,” Botwinick said. “This is a common mistake – don’t make the same one.”

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