Thorough tax planning is essential to preserve an estate’s value. A proper estate plan can avoid many of the tax pitfalls that can adversely affect inheritance or incur unnecessary expense for the heirs. A good estate plan will guard against these pitfalls in preparation for death, but also, plan for and protect the value of any lifetime property transfers.
Tax basics involving transfers of property can be broken down into two types: transfers on or after death and transfers before death.
Depending on your wishes and goals for retirement, long-term care needs, succession plans, and the wishes of other participants in the operation, extensive tax planning should be kept in mind to avoid any burdens on the transferors or transferees.
The biggest tax issue with property transfers is capital gains tax and depreciation recapture. These tax burdens can be substantial if not planned out carefully using an estate, succession, or business plan. Much of the tax burden arises because the property has been owned for a long time and it has a low tax basis but has gone up on value and now has a high fair market value. Basis is defined by the IRS as the amount of your capital investment in property, or in most situations, the basis of an asset is its cost to you.
The following is a good example of how to explain tax basis: John owns 160 acres he bought in 1970 for $300 per acre for a total cost of $48,000. As of August 1, 2018, that same 160 acres has a fair market value of $3,000 per acre, or $480,000. If John sold his 160 acres on August 1, 2018 for $480,000 or $3,000 per acre, John’s basis would be $48,000 (what the property cost John in 1970) and the current fair market value would be $480,000. Because of this low basis in the land and it’s current high fair market value, John would pay a capital gains tax on the difference between $480,000 and $48,000 (his gain) which is $432,000. This capital gains tax rate on this gain could be up to 20% or $86,400 ($432,000 x 20%).
The best way to avoid a large capital gains tax on the sale of a long-held asset is to receive a step-up in basis. A step-up in basis occurs only when the property passes from a decedent to a person inheriting the property. In the above example, if John had a child and John died on July 31, 2018 and the child inherited the property and sold it on August 1, 2018, there would be no capital gains tax because there would be no gain as the child received a step-up in basis from $48,000 to $480,000.
In addition to these larger tax considerations, other tax considerations include the filing of income taxes during the year of an individual’s death, as well as yearly payment of property taxes on any taxable property the person owns.