Taxes and Estate Planning

One of the most consistent questions that we come across involves taxes. For estate planning purposes, there are three (3) distinct types of taxes that may impact your estate plan. 

1. Estate & gift tax

The estate and gift taxes are transfer taxes. They are federal only. California does not impose an estate or gift tax.

• Transfer taxes tax the transfer of an asset. The estate tax is imposed when someone transfers something upon death (think: inheritance) and the gift tax is imposed when it’s a lifetime gift (think: birthday present).

• Who pays it? Always the person making the transfer (aka the estate of the person who died, or the person giving the gift). 

Not all transfers are taxed. There is an exemption amount that must be exceeded before the tax kicks in. The current exemption amount for an individual is $11.7 million*, and for a married couple it’s $23.4 million*. In other words, you need to have more than $11.7 million or $23.4 million in net assets to have to pay any estate tax. 

The gift tax is related to the estate tax. This is how: every year, every single person can give any other person $15,000* without reporting it to the IRS. A married couple can double that amount. If you exceed the amount, then you have to report it to the IRS. But instead of paying tax on it, your estate tax exemption amount is reduced by the fair market value of the item gifted. 

Example: If you love this blog, and you’re married, you can give Natasha $30,000 this year without reporting it to the IRS. If you love it SO much, you could give Natasha $31,000, but then you have to report that extra $1,000 to the IRS. The IRS then takes your $1,000 and reduces your estate tax exemption amount by $1,000. So instead of being $23.4 million exemption, it would be $23.4 million MINUS $1,000. 

*This is the amount for 2021. Each year this amount is adjusted for inflation. 

2. Income tax (capital gains taxes)

Income tax, as you know, is both state and federal. For purposes of this section, we’re focusing on capital gains taxes (profit made when selling something) and not your wage income (income made going to work).

If you buy something for an amount and it increases in value, and then you sell it, you have to pay taxes on that increase in value, which is called a gain. A capital gain is a profit from selling a capital asset, which is basically anything that is substantial in nature, excluding cash or retirement accounts (think: real estate, stocks, heavy machinery, artwork, collectibles, etc.). 

Example: You buy your house for $1 million. It increases in value to $4 million and you sell it. You’ve “earned” $3 million on the house. You have to pay capital gains taxes on the increase in value of $3 million. Your capital gains taxes are part of your income tax. 

Importantly, built-in capital gains get zeroed out when someone dies. 

Example: You buy your house for $1 million. It increases in value to $4 million, and you die. Whoever gets your house (spouse, child, etc.) retains it at the value of $4 million. If they sell it the minute that you died, then they do not pay any capital gains. If they hold on to it until it’s worth $10 million and sell it, then they would pay capital gains taxes based on $6 million in gains ($10 million - $4 million, date of death value), rather than $9 million ($10 million - $1 million, purchase price). 

3. Property tax 

Property tax is imposed by the county in which the property sits. We are bolding this because it’s important and has come up numerous times with Prop 19. To repeat: property tax is a COUNTY tax. It’s not state. It’s not federal. It’s local. 

Property tax is paid in two installments, annually. It is calculated based upon an “assessed value” and is only adjusted when a property is reassessed in value, which happens most often when it changes ownership on title. 

For the most part, property taxes are adjusted anytime the property changes hands, with certain exceptions. If you plan on transferring property to your children, or to your parents, then there are certain benefits afforded to these discrete transactions. Proper planning is critical to avoid unnecessary increases in property tax.

Why does this matter? 

It is crucial not to conflate or confuse the three taxes described above. Proper tax planning within the context of estate planning requires keeping each analysis separate. Tweaking a transaction to gain a benefit through one tax analysis may increase your tax exposure with one of the other taxes. Ultimately, you are best off planning ahead and trying to anticipate pitfalls before they happen, especially when it comes to intergenerational transfers. Contact us to discuss your specific situation and to work through your goals for your family.