Ever-changing laws and regulations require regular review of financial and legal documents to implement necessary updates.
We all have an estate plan in place (shame on you if you don’t ;-) ) and odds are that if you do have one, some parts of it may no longer be valid. Things such as who would get the kids if something happened to both of you, who do you want to make financial decisions on your behalf if you are incapacitated, etc. All those lovely moments that we honestly never want to think about (I can’t blame you).
I should point out before you dive into this article that my role as a financial planner is to look at the overall picture. In this particular case, the clients will ultimately be working with their CPA and their estate plan attorney to implement changes. If after reading this article you have questions about your own situation, please do not hesitate to reach out.
Recently, I came across a very interesting case of a fairly advanced estate plan that I would say had expired in terms of its effectiveness given current estate tax laws. When it was originally implemented some 20 years ago, it was a good plan. However, the laws have changed since then, essentially negating some of the benefits sought by the original plan.
The plan was set up where a parent had put a rental (worth ~$750k) they owned into an LLC filing as a Partnership. He was the majority owner (55%) and the General Partner (he’s 100% in control). He gifted a 15% interest to each of his three kids who were the Limited Partners (45% but no control). The idea behind the original structure was to transfer some of the value of the property out of his estate in order to save estate taxes. At the time this was done, the estate tax exemption was somewhere between $600k and $675k and the dad’s estate was well over $1M; it made sense to transfer some of the value out of the estate to avoid estate taxes. However, since that estate plan was created, the estate tax exemption has increased to $5.49M. With a net worth of around $1.5 million today the need to transfer assets out of his estate no longer exists. In fact, it’s just the opposite.
One of the benefits of investment real estate is the step-up in cost basis at death. Dad originally paid ~$600k for the property, since then it has appreciated to ~$750k according to his estimates. On the surface it looks like there would only be a gain of $150k that he would have to pay capital gains tax on if he sold it today, but it’s far greater than that. Because he’s been depreciating the property for ~20 years now his “adjusted cost basis” is much lower. We don’t know exactly how much he’s depreciated so far but if he paid $600k for the property and 80% of the value of the property is the building, the IRS lets you depreciate the building over 39 years but you can accelerate it to 27.5 years. (Most people opt for the shorter depreciation period because it’s more tax friendly early on, so let’s assume that dad did as well.) That means he would’ve been deducting $17,454 ($600k x 80% / 27.5yrs) per year to help offset the rental income. Over 20 years he would’ve depreciated the property by $349,091 leaving an adjusted cost basis of $250,909. As a result, if he sold it today, he would pay capital gains tax (15% in his case) on the $150k gain ($750k-$600k) but he would also pay taxes on the recapture of the $349,091 that he depreciated over all those years. Like everything with our ridiculously complicated tax code, calculating the taxes on the deprecation recapture is not easy. When calculating the taxes owed on the depreciation recapture we have to look at how much was done under the straight-line method and how much was done under the accelerated method because they are taxed at different rates. Using the 39 year straight-line depreciation method for commercial real estate, dad would have been able to depreciate $12,308 ($600k x 80% / 39yrs) per year for a total of $246,160 after 20 years. The tax rate on the 39 year straight-line depreciation recapture is 15%. The remaining depreciation recapture from the accelerated depreciation method of 27.5 years is $102,931 ($349,091 - $246,160) which is taxed at 25%. So, in this example, if dad sold the property today, he would pay $22,500 ($150,000 x 15%) in capital gains taxes plus $36,924 ($246,160 x 15%) in straight-line depreciation recapture, plus $25,733 ($102,931 x 25%) in accelerated depreciation recapture for a total tax bill of $85,157.
Note: This does not take into account the fact that if dad’s income was over $250k that he would have to pay the 3.8% Obamacare surtax as well.
After all of that, I should point out that dad does not want to sell, not because of all of the taxes he would owe, but because it’s paying him ~$54k a year in rent (after expenses) which is a very good yield relative to the value of the property.
Now for the reasoning behind why I titled this case study “The Gift That Keeps on Taking”. Under the current estate tax exemption of $5.49M his kids would be better off if they didn’t own the 45% (15% each) that was gifted to them. If he were to pass today, only dad’s portion of the property (55%) would receive a step-up in basis, while the kids’ share (45%) would not, which means that if they sold the property, they would have to pay taxes on both the capital gains and depreciation recapture for their share.
Note: I should point out at this time that dad is only distributing enough money from the kids’ interest in the property to cover the income taxes they owe on their share of the rental income. There is no real benefit today to the kids owning 45% of the property.
One way to undo this for the kids is to gift their interest in the property back to dad so that he owns 100% of the property. (There are gifting limits, so this has to be done properly) That way, the entire property receives the step-up in cost basis after dad’s passing. This would make things simpler from an accounting standpoint as well, because the kids no longer have to account for undistributed the income they receive from the property, and the LLC’s return will have just one member instead of four. It’s a win-win all around.
To proceed with the gifting, they would first need to have the property appraised so that they can determine the fair market value of their 15% interests. For the sake of this article, let’s assume that dad’s estimate of $750k was right, then each kid’s interest would be worth $112,500. To gift their 15% interest back, each kid is going to deduct $14,000 of it off under the Annual Exclusion and then the remaining $98,500 will come off their Lifetime Exemption.
Annual Exclusion: Everybody can give away $14,000 per year to as many people as they want. As soon as they give more than that to any one person they have to choose whether to pay the gift taxes (currently 40%) on the excess amount or take it against their Lifetime Exemption.
Lifetime Exemption: Right now you can give away up to $5.34M in your lifetime. Any gifts you make under the Annual Exclusion do not reduce it. When you make a gift in excess of the Annual Exclusion you need to file IRS form 709 so that it can be deducted against your Lifetime Exemption.
As a result, each kid will have to file IRS form 709 for the $98,500 that they took against their Lifetime Exemption but they will not owe any taxes. The benefit comes in when they ultimately inherit the property someday; they will receive it with a fully stepped-up basis and will pay NO taxes on capital gains or depreciation recapture.
As you’ve probably heard us say time and time again, the only constant in all of this is “change”. This is why it is imperative to work with a team of professionals who look at these matters regularly and examine them from multiple angles to see if anything needs to be updated. At CWM we examine your finances as a whole, and coordinate with other professionals to make sure you are getting the best care from all angles. As a team of financial consultants and coaches, our role is to help you bring together all of the pieces of your financial life – for you and your next generation.
Brian J. Lockett, CFP®
Vice President, Wealth Manager
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