The Federal Estate Tax vs. The Capital Gains Tax

Avoiding the two “death” taxes, Federal Estate Tax and Capital Gains Tax, is a lot like playing “Whack-a-mole.”If you have ever been to an arcade, you’re probably familiar with this game. The goal of this game is to take the mallet and try to hit the furry thing that looks like a mole when it pops up. The challenge is as soon as you whack one furry thing, the mole, another one pops up. Then you whack that mole and another one will pop up. This goes on for several minutes. At the end of the session, you are given a score representing how many moles you were able to whack.

Unfortunately, unlike Whack-a-mole, trying to avoid taxes when you pass away, is not a game and your heirs could end up paying a lot of money in unnecessary taxes.

Specifically, there are two taxes that need to be addressed at the death of an individual, the Federal Estate Tax and the Capital Gains Tax.

What is the Federal Estate Tax?

Let’s understand the Federal Estate Tax first. This is a tax imposed on all of the assets in your estate that exceed a certain amount. For example, your house, your retirement accounts, savings accounts, checking accounts, brokerage accounts, life insurance proceeds, basically everything you own. Unfortunately, the amount that you can leave in your estate without being subjected to the Federal Estate Tax, usually changes every year. For example, in 2010, the Federal Estate Tax was repealed for one year. Everyone who died that year, regardless of the value of their estate, transferred all of their assets to their heirs without paying one single cent in Federal Estate Taxes! If Bill Gates had died in 2010, not one penny would have gone to the IRS. However, the following year, the Federal Estate Tax was reinstated and any estate in excess of $5 million was exposed to the Federal Estate Tax. If this tax is triggered, the amount taxed can be as high as 40%!

The problem in planning to avoid this tax is you don’t know what year you are going to die, you don’t know what the size of your estate will be and you don’t know what the maximum amount that your estate can equal without triggering the Federal Estate Tax. Planning with so many unknown variables is a tremendous challenge. However, there is a tax planning provision that can be included in a married couple’s Trust that will double the amount that can be transferred to their heirs without triggering the Federal Estate Tax. Consequently, many estate planning attorneys include this provision in the Trusts they prepare assuming that it is better to plan to avoid the Federal Estate Tax, whether or not your estate will be subject to this tax. However, there is a catch. Planning to avoid the Federal Estate Tax might trigger a Capital Gains Tax and the Capital Gains Tax might be greater than the Federal Estate Tax!

What is the Capital Gains Tax?

Now let’s review the Capital Gains Tax. With very few exceptions, almost everyone has at least one asset that has appreciated in value during their lifetime. If this asset is sold, a Capital Gains Tax is often triggered. This is calculated by subtracting the “cost basis” of the asset (essentially the purchase price)from the sale price. This amount is then included on your tax return. For example, if you purchased your home for $100,000 and it is worth $600,000 when you sell it, you have realized a $500,000 capital gain which is then added to your income tax return.

The good news is when you pass away, all your assets can receive an adjusted cost basis. This is referred to as a “step-up” in basis. Basically, all the appreciation that would have triggered a capital gain had the decedent sold the assets while they were alive, is eliminated. If the children were to sell everything in the estate relatively soon after the decedent died, there would be no capital gain. In the previous example, the cost basis of the home ($100,000) is “stepped-up” to the date of death value of $600,000, eliminating the capital gain. This step-up in basis can occur on all your assets, not just the home. It can occur on rental properties, securities, and investments, just to name a few. Because almost everyone has experienced appreciation on at least one asset (most often their home)it would appear that this “step-up” in basis is appropriate for everyone.

However, there is a catch. Planning to avoid the Capital Gains Tax on all assets transferred might trigger a Federal Estate Tax and the Federal Estate Tax might be greater than the Capital Gains Tax.

This is truly a “catch 22.” Like “Whack-a-mole,” when you “whack” the Federal Estate Tax, the Capital Gains Tax pops up. When you “whack” the Capital Gains Tax, the Federal Estate Tax pops up. Unfortunately, the law requires that you make a decision as to which tax you want to avoid.

What Tax Should You Plan To Avoid?

So, the question is which tax should you plan to avoid when the variables (the estate size and the limit) keep changing? One solution is to plan your estate and make the decision as to which tax you want to avoid as if you were going to die that year. Then meet with your planning lawyer every year thereafter and re-do the Trust based on the circumstances that year. This is not only expensive, but very impractical. Most Trust documents are never reviewed or updated after they have been created.

The exciting news is several years ago, we discovered a tool that can be included in the Trust that would allow the surviving spouse to decide which tax they wanted to avoid after the first spouse dies. This is a huge advantage because the surviving spouse can calculate exactly what the size of the estate is, what the Federal Estate Tax limit is, and what the Capital Gains Tax is going to be. He or she is then able to decide which course of action will result in the lowest tax. Most often this decision takes less than 15 minutes to make, but believe it or not, the IRS gives you up to 15 months after the first spouse’s death to make the decision!

Shouldn’t this tool be in every Trust ever created for married couples? Why is it that in the thousands and thousands of Trusts that we have reviewed (even those documents drafted within months of our review) this tool is usually missing. Unfortunately, most people reviewing their Trust documents are not likely to determine whether this language is included in their Trust. After all, the Trust is written in very complicated language.

We can quickly show you where to look in your Trust documents and determine whether you are adequately protected and make the appropriate tax reduction decision.