There is an old saying, “no one plans to fail; they only fail to plan.” This is often the case when it comes to transferring assets and to estate planning in general. One reason missed opportunities occur so frequently is due to a consistent myth that estate planning is only for the wealthy. The truth is that estate planning is not only something everyone should consider, but it also goes well beyond the top-of-mind items of wills and trusts.
Here is an example of someone who could have avoided paying over $50,000 in taxes had they planned their transfer differently:
John and Jane own farmland held entirely in John’s name.
Upon John’s death in 2003, he leaves 50% of the farm to Jane and the other 50% is split between their two daughters. This leaves an ownership situation of 50% to Jane, 25% to daughter 1, and 25% to daughter 2.
This transaction seems like a decent idea on the surface; however, it gives each of the daughters a “cost basis” in the farm based on the date of the father’s death. Assuming the value of the farm is $500,000, the result is a basis of $250k to Jane, $125k to daughter 1, and $125k to daughter 2. Now let’s fast forward a little over 10 years:
Jane passes away and leaves the rest of the farm to her two daughters in equal amounts. They immediately put the property up for sale and receive $1.5 million total in proceeds, which they split $750k each.
Once again, this sounds like a good deal. Each of the daughters receives $750k in cash from the sale of the family farm. The surprise comes when they must pay over $50,000 each in taxes that could have been avoided. Here’s why:
At Jane’s death, the assets she will pass on receive an increase in cost basis to the date of death value of $750k. The basis that is transferred to the daughters is $750k split in half, or $375k to each daughter. Add this $375k to each daughter’s current $125k basis from the assets inherited from their father in 2003, and they now own property with a cost basis of $500,000 each, or one million total. When the farmland is sold for $1.5 million after their mother’s death, the daughters recognize $500k as a taxable gain, or $250k each. Due to the high income in the year of sale, a host of other consequences increases the daughters’ taxes well beyond the 15% capital gains rate. Items increasing the total tax liability include net investment income tax, alternative minimum tax, taxes on Social Security benefits that otherwise would have been tax free, and state income taxes.
Here’s a better idea.
There is a better planning strategy. If John had chosen leave the farm 100% to his wife instead of including his daughters, the $750,000 inheritance they each received at Jane’s death would have DECREASED their taxes by giving them a deduction. Their new cost basis in the farm would have been the $1,500,000 – the date of death value. The deduction comes from the transaction costs involved in selling the farm, such as realtor commissions and closing costs.
When you meet with your Certified Financial Planner™ professional, make sure you understand the consequences of how your assets will transfer. A little bit of planning now can pay big dividends in the future.
Andrea L. Blackwelder, CFP®, ChFC and Joseph D. Clemens, CFP®, EA are the founders and partners of Wisdom Wealth Strategies. Their shared passion is simple: to bring financial empowerment, understanding, and peace-of mind to people who wish to improve their financial future, build wealth for their families, and achieve financial independence. Click here to find out more about how you can work with Wisdom Wealth Strategies.