Tax Planning

Like Bill Murray waking up every morning to another Groundhogs Day, I hear some version of the same question almost daily. My clients want to know, “Should I give my home (or cabin or farm) to my kids now to so I don’t lose it to the nursing home?” The answer, as is the case with so many legal questions, is not as straight forward as you may expect.

The answer depends on your goals, your other assets, your family, your health, and what other planning tools are available to you. After some follow-up questions, it usually turns out my clients aren’t as concerned with Medical Assistance eligibility as they are about taxes. In these cases, gifting the other direction may provide greater benefit.

The estate tax exemption won’t always be so high. The runup in real estate prices may mean capital gains taxes become a serious issue for many people. There are solutions to be found in estate planning, including one known as an “Upstream Power of Appointment” Trust, as explained in the article “How to Use Your Estate Plan to Save on Taxes While You’re Still Alive!” from Kiplinger.

To be clear: strategies like this one are not for everyone, but rather estate planning tools that have a proper time and place. It requires the right types of property and a completely trustworthy, elderly and less wealthy relative, such as a parent, aunt, or uncle, to serve as an additional trust beneficiary. First, here is some background information:

  • Basis: This is the amount by which a price is reduced to determine the taxable gain. This is often the historical cost of an asset, which may be adjusted for depreciation or other items. Estate planning attorneys are familiar with these terms.
  • Step-up in basis: If you bought a cabin for $100,000 and sold it for $400,000, your taxable gain would be $300,000. However, if the cabin had belonged to your father and was being sold following his death to distribute assets between you and your siblings, the basis (cost) would be increased to the fair market value at the date of your father’s passing. This increase is known as the “step-up in basis” and here’s the benefit: there would be no capital gain on the sale and no taxes owed.
  • Carry-over basis: In the case of lifetime gifting, the person receiving the gift also receives the original basis. If you bought a cabin for $100,000 and later gifted that cabin to your kids, they receive your basis of $100,000. If they later sell the cabin for $400,000, they will pay tax on the capital gain of $300,000.
  • Federal lifetime estate tax exemption: This is currently at $12.06 million per person or $24.12 for married couples. This is the amount of assets which can be passed to children or others free of any federal estate tax. However, the number will take a deep dive on January 1, 2026, when it reverts back to just under $6 million, adjusted for inflation. Plan for the change now, because 2026 will be here before you know it!

Upstream planning involves transferring certain appreciated assets to older or other family members with shorter life expectancies. Since the person is expected to die sooner, the basis step-up is triggered sooner. When the named person dies, you obtain a basis step-up on the asset, saving income taxes on depreciation and saving capital gains on a future sale of the property.

To make this happen, your estate planning attorney will need to give an elderly person (let’s say Aunt Rose) the general power of appointment over the asset. Section 2041 of the Internal Revenue Code says you may give your Aunt Rose a power to appoint the asset to her estate, creditors, or the creditors of her estate. Providing the power will include the value of the property in her estate, not yours, ensuring the basis step-up and income tax savings.

Don’t do this lightly, as a general power of appointment also gives Aunt Rose ownership and the right to give the property to herself or anyone she wishes. Can you protect yourself, if Aunt Rose goes rogue?

While the IRC rule doesn’t require Aunt Rose to get your permission to control or change distribution of the property, a trust can be crafted with a provision to effectuate the desired result. For example, trust provisions could require the additional approval of a third-party. Additionally, the IRC doesn’t require Aunt Rose to know about this provision, and in many cases the relative will understand the strategy and be on-board. This is why the best person for this role is someone who you know and trust without question and who understands your wishes and the desired outcome.

Proper planning with an experienced estate planning attorney is a must for this kind of transaction. All the provisions need to be right: the beneficiary need not survive for any stated period of time, you should not lose access to the assets receiving the basis increase, you want a formula clause to prevent a basis step down if the property or asset values fall and you want to be sure that assets are not exposed to creditor claims or any other liabilities of the person holding this broad power.

Contact our firm if you would like to review your options for asset protection and tax minimization.

Reference: Kiplinger (July 3, 2022) “How to Use Your Estate Plan to Save on Taxes While You’re Still Alive!”

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