The absolute basics on one’s estate planning are to have a valid living Trust, a backup Will for that Trust and a Medical Durable Power of Attorney. These documents allow for a predictable handling of one’s estate and the avoidance of the expense, delays and public exposure involved in a Probate. A Medical Durable Power of Attorney allows one to avoid unnecessary medical care and expense if a loved one determines that one cannot return to a decent and respectable life following a serious medical condition.
After one has these basics in place then it may or may not be necessary to start looking at additional estate planning opportunities. These would include such things as a gift giving program, corporation(s) and/or LLC(s) that will be used for income tax and estate tax savings, insurance trusts, charitable remainder trusts and a bountiful number of other tax savings strategies that will be very much needed and wanted by larger estate owners not only for tax savings purposes but as well for asset protection during life and at the time of death.
An important additional estate planning concern, applicable to virtually every home owner in the country having a personal residence and seeing it at its highest value ever is the subject of the balance of this article, i.e. some information and ideas on dealing with your highly appreciated personal residence:
Currently IRS Code Section 121(b) allows an individual to exclude from income up to $250,000 of gain, ($500,000 on a joint return) that is realized on a sale or exchange of a principal residence. This exclusion may be used every two years if the subject property was a principal residence for two years or more during the five year period that ends on the sale or exchange of the property.
In today’s real estate market many people exceed their $250,000/500,000 exclusion amount, and if such a property were to be sold or exchanged, capital gains rates would have to be paid on federal and state levels for the excess of those gains. One idea for avoiding this tax is to not sell and hold on to the property for your heirs to receive it from your estate and the capital gains tax will be avoided.
For example: If a married couple owns a home that they paid $200,000 for and it is now worth $1,200,000 there would be a $1,000,000 gain on the sale of that property, $500,000 would be excluded under Section 121(b) and the other $500,000 would be taxable capital gain whether one were to buy a new property or just keep the proceeds.
On the other hand if one were to hang on to the property, at the date of death the property would have a “step-up” in basis (this means that instead of having a $200,000 property with a $1,000,000 gain in the hands of your heirs, they would have a $1,200,000 property with no taxable capital gain) i.e. At the time of death the cost basis would be “stepped-up” from $200,000 to 1,200,000.
As regards estate (death) taxes, each person has at this time a $1,500,000 federal estate tax exemption. No estate taxes would be levied on the first $1,500,000 of net assets that an individual has and this is $3,000,000 for a married couple.
My next suggestion regarding your highly appreciated personal residence is to consider converting it into an income producing asset and avoid all the capital gains tax on the sale of the property by entering into a tax free (1031) exchange. The new property can be one that is owned entirely by yourself or one where you have a percentage ownership of a larger income producing residence or commercial property.
The cautions here are that the IRS must believe that you converted your personal residence into a rental property. This can be done by renting the property, preferably to a non-relative, friend or business associate, at a fair market rental and for a legitimate period of time. Under current law a legitimate period of time is two years or more (IRS letter ruling 8429039). However, properties that are rented for less than this time can benefit from these conversions from personal residences to income producing assets and it can be successfully argued that a property acquired rental property status even though done for 18 months or even one year — this of course cannot be done with the same level of certainty that one will have by renting the property for two years or more.
If all fails, there is a reasonable safety net on all of this — which is that the top federal tax rate on long terms capital gains is a somewhat palatable 15%.