Capital gains taxes take on added importance

Thanks, Congress.

That’s usually said with a tinge (or more) of sarcasm. But when legislators made permanent the estate tax and gift tax exemptions last year, the upshot was that many of our clients no longer have to pay estate taxes.

The individual exemption is at $5.34 million this year, and it’s expected to rise to $5.43 million in 2015 because it’s adjusted for inflation every year. For a married couple, that’s $10.68 million this year and $10.86 million next year, and that, The Motley Fool says, means that only about two out of every 1,000 individuals or couples have to worry about paying the top tax rate of 40 percent.

With the top estate tax bracket essentially out of bounds for all but the wealthiest people, the game has changed. New rules, say The Wall Street Journal, allow for tax savings that most people have been unaware of – and that could contradict advice from the past.

Capital idea

In the past, trying to avoid the estate tax meant not taking advantage of all the strategies to minimize long-term capital gains taxes. When the top capital gains tax rate was 15 percent, it wasn’t such a big deal, but now that the top federal rate is nearly 24 percent, careful planning is in order.

One way to avoid or minimize federal capital gains taxes is to take advantage of the step-up in basis rules. If your clients bought a stock or piece of land 20 years ago at $10,000 and sells it today when it’s worth $100,000, they would owe capital gains tax on the $90,000 profit.

However, the Journal says, if your client holds the asset until death, the capital gains tax vanishes. The stock or land can be included in your client’s estate at full market value where the personal estate exemption could shield it from federal estate taxes as well.

In the nine states with community property laws, including Texas and California, a surviving spouse gets the full step-up in basis advantage. In most other states, the step-up is worth half the value of a joint asset after one spouse dies.

Trust troubles

Tax-savings trusts aren’t the be-all, end-all to minimize a tax burden, the Journal says, because of the portability rule that came into effect in 2011. With this provision, a surviving spouse can claim the unused portion of a partner’s federal estate tax exemption and add it to her own. So if a spouse had $4 million left, the survivor could add that to her $5.34 million exemption for $9.34 million total.

However, trusts set up years ago under old rules could raise taxes for heirs because the step-up in basis doesn’t apply. For example, say a spouse dies and leaves $1 million to an estate trust under 2007 rules; there will be no step-up in basis on the future growth of those assets, leaving the gains taxable. But if the decedent leaves those assets to a surviving spouse, an increase on those assets could avoid capital gains taxes at the second death.

Keep in mind, however, that tax-saving trusts can still be a viable option for couples with state death taxes. And trusts can be a good way to protect assets if one spouse is a U.S. citizen but the other is not.

Give – but wait

Bestowing gifts might not be the best way for your clients to go when planning their estates, the Journal says. Unless there’s a huge estate or someone needs help or there are state taxes to consider, there’s almost no reason to make gifts anymore.

Keeping the step-up in basis can be crucial.

For example, if your client gave her niece a piece of land that she bought for $1,000 that’s now worth 10 times that, the niece’s cost basis would be $1,000 when she sells the land. And that would mean the niece would owe capital gains taxes on the $9,000 the land appreciated.

But if your client leaves the land at death, the step-up provision would mean the niece, if she sells the land, would only owe capital gains taxes on anything above $10,000.

With estate exemptions high and getting higher every year, experts say, avoiding the long-term capital gains rate of 23.8 percent is more paramount than ever, and waiting for the step-up in basis can be the best way to do that.