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NO SURPRISES: WHY YOU SHOULD CHECK YOUR TAX BRACKET & ESTATE PLANNING PORTABILITY LIVES ON UNDER THE TCJA
NO SURPRISES: WHY YOU SHOULD CHECK YOUR TAX BRACKET
Many taxpayers learned some tough lessons upon completing their 2018 tax returns regarding the changes brought forth by the Tax Cuts and Jobs Act (TCJA). If you were one of them, or even if you weren’t, now’s a good time to check your bracket to avoid any unpleasant surprises next April.
Under the TCJA, the top income tax rate is now 37% (down from 39.6%) for taxpayers with taxable income over $500,000 for 2018 (single and head-of-household filers) or $600,000 for 2018 (married couples filing jointly). These thresholds are higher than they were for the top rate in 2017 ($418,400, $444,550 and $470,700, respectively), so the top rate probably wasn’t too much of a concern for many upper-income filers.
But some singles and heads of households in the middle and upper brackets were likely pushed into a higher tax bracket much more quickly for the 2018 tax year. For example, for 2017 the threshold for the 33% tax bracket was $191,650 for singles and $212,500 for heads of households. For 2018, the rate for this bracket was reduced slightly to 32% — but the threshold for the bracket is now only $157,500 for both singles and heads of households.
So, a lot more of these filers found themselves in this bracket and many more could so again in 2019. Fortunately for joint filers, their threshold for this bracket has increased from $233,350 for 2017 to $315,000 for 2018. The thresholds for these brackets have increased slightly for 2019, due to inflation adjustments. If you expect this year’s income to be near the threshold for a higher bracket, consider strategies for reducing your taxable income and staying out of the next bracket. For example, you could take steps to accelerate deductible expenses.
But carefully consider the changes the TCJA has made to deductions. For example, you might no longer benefit from itemizing because of the nearly doubled standard deduction and the reduction or elimination of certain itemized deductions. For 2019, the standard deduction is $12,200 for singles and married individuals filing separately, $18,350 for heads of households and $24,400 for joint filers.
ESTATE PLANNING PORTABILITY LIVES ON UNDER THE TCJA
When the TCJA was passed, the big estate planning news was that the federal gift and estate tax exclusion doubled from $5 million to an inflation-indexed $10 million. It was further indexed for inflation to $11.18 million for 2018 and now $11.4 million for 2019.
Somewhat lost in the clamor, however, was (and is) the fact that the new law preserves the “portability” provision for married couples. Portability allows your estate to elect to permit your surviving spouse to use any of your available estate tax exclusion that is unused at your death.
A brief history
At the turn of this century, the exclusion was a mere $675,000 before being hiked to $1 million in 2002. By 2009, the exclusion increased to $3.5 million, while the top estate tax rate was reduced from 55% in 2000 to 35% in 2010, among other changes.
After a one-year estate tax moratorium in 2010, the Tax Relief Act (TRA) of 2010 reinstated the estate tax with a generous $5 million exclusion, indexed for inflation, and a top 35% tax rate. The American Taxpayer Relief Act (ATRA) of 2012 made these changes permanent, aside from increasing the top rate to 40%.
Most important, the TRA authorized portability of the estate tax exclusion, which was then permanently preserved by the ATRA. Under the portability provision, the executor of the estate of the first spouse to die can elect to have the “deceased spousal unused exclusion” (DSUE) transferred to the estate of the surviving spouse.
How the DSUE works
Let’s say Kevin and Debbie, who have two children, each own $5 million individually and $10 million jointly with rights of survivorship, for a total of $20 million. Under their wills, all assets pass first to the surviving spouse and then to the children.
If Debbie had died in early 2019, the $10 million ($5 million owned individually and $5 million held jointly) in assets would be exempt from estate tax because of the unlimited marital deduction. Thus, her entire $11.4 million exclusion would remain unused. However, if the election is made upon her death, Kevin’s estate can later use the $11.4 million of the DSUE from Debbie, plus the exclusion for the year in which Kevin dies, to shelter the remaining $8.6 million from tax, with plenty to spare for some appreciation in value.
What would have happened without the portability provision? For simplicity, let’s say that Kevin dies later in 2019. Without being able to benefit from the unused portion of Debbie’s exclusion, the $11.4 million exclusion for Kevin in 2019 leaves the $8.6 million subject to estate tax. At the 40% rate, the federal estate tax bill would amount to a whopping $3.44 million.
Although techniques such as a traditional bypass trust may be used to avoid or reduce estate tax liability, this example demonstrates the potential impact of the portability election. It also emphasizes the need for planning.
Other points of interest
Be aware that this discussion factors in only federal estate taxes. State estate taxes may also have a significant impact, particularly in some states where the estate tax exemption isn’t tied to the federal exclusion.
Also, keep in mind that, absent further legislation, the exclusion amount is slated to revert to pre-2018 levels after 2025. Portability continues, although, for those whose estates will no longer be fully sheltered, additional planning must be considered.
Furthermore, portability isn’t always the best option. Consider all relevant factors, including nontax reasons that might affect the distribution of assets under a will or living trust. For instance, a person may want to divide assets in other ways if matters are complicated by a divorce, a second marriage, or unusual circumstances.
Every estate plan includes details that need to be checked and rechecked. Our firm can help you do so, including deciding whether portability is right for you.
ARCHIVE OF PAST MONTHLY NEWSLETTERS
Jun 2019: Consider the Tax Advantages of Qualified Small Business Stock & Vacation Homes: Do You Understand the Tax Nuances?
While the Tax Cuts and Jobs Act (TCJA) reduced most ordinary-income tax rates for individuals, it didn’t change long-term capital gains rates. They remain at 0%, 15% and 20%.
The capital gains rates now have their own statutory bracket amounts, but the 0% rate generally applies to taxpayers in the bottom two ordinary-income tax brackets (now 10% and 12%). And, you no longer must be in the top ordinary-income tax bracket (now 37%) to be subject to the top long-term capital gains rate of 20%. Many taxpayers in the 35% tax bracket also will be subject to the 20% rate.
So, finding ways to defer or minimize taxes on investments is still important. One way to do that — and diversify your portfolio, too — is to invest in qualified small business (QSB) stock.
To be a QSB, a business must be a C corporation engaged in an active trade or business and must not have assets that exceed $50 million when you purchase the shares.
The corporation must be a QSB on the date the stock is issued and during substantially all the time you own the shares. If, however, the corporation’s assets exceed the $50 million threshold while you’re holding the shares, it won’t cause QSB status to be lost in relation to your shares.
Two tax advantages
QSBs offer investors two valuable tax advantages:
1. Up to a 100% exclusion of gain. Generally, taxpayers selling QSB stock are allowed to exclude a portion of their gain if they’ve held the stock for more than five years. The amount of the exclusion depends on the acquisition date. The exclusion is 100% for stock acquired on or after Sept. 28, 2010. So, if you purchase QSB stock in 2019, you can enjoy a 100% exclusion if you hold it until sometime in 2024. (The specific date, of course, depends on the date you purchase the stock.)
2. Tax-free gain rollovers. If you don’t want to hold the QSB stock for five years, you still have the opportunity to enjoy a tax benefit: Within 60 days of selling the stock, you can buy other QSB stock with the proceeds and defer the tax on your gain until you dispose of the new stock. The rolled-over gain reduces your basis in the new stock. For determining long-term capital gains treatment, the new stock’s holding period includes the holding period of the stock you sold.
More to think about
Additional requirements and limits apply to these breaks. For example, there are many types of businesses that don’t qualify as QSBs, ranging from various professional fields to financial services to hospitality and more. Before investing, it’s important to also consider nontax factors, such as your risk tolerance, time horizon and overall investment goals. Contact us to learn more.
VACATION HOMES: DO YOU UNDERSTAND THE TAX NUANCES?
Owning a vacation home can offer tax breaks, but they may differ from those associated with a primary residence. The key is whether a vacation home is used solely for personal enjoyment or is also rented out to tenants.
Sorting it out
If your vacation home is not rented out, or if you rent it out for no more than 14 days a year, the tax benefits are essentially the same as those you’d receive if you own your primary residence. In this scenario, you’d generally be able to deduct your mortgage interest and real estate taxes on Schedule A of your federal income tax return, up to certain limits. Also, you may exclude all your rental income.
But the rules are different if you rent out your vacation home for 15 or more days annually. First, the rental income must be reported. Second, in this scenario, the IRS considers your vacation home to be an investment property and, thus, allows deductions related to the rental of the property, with certain limitations. In addition to mortgage interest and real estate taxes, these deductions generally include insurance, utilities, housekeeping, repairs and depreciation. Also, the deduction for certain categories of expenses cannot exceed the rental income.
If you exceed this number of days of rentals and use your vacation home for personal use, these deductions will be limited by the ratio of actual rental days to the total days of use of the home. Suppose, for example, that you personally use your vacation home for 25 days and rent it for 75 days in a year, so the home is used for 100 total days. Here, you would be allowed to deduct 75% of the expenses listed above as rental expenses. Be aware that a portion of the mortgage interest and real estate taxes may be deductible on Schedule A. In certain circumstances, however, the personal portion of your mortgage interest may not be deductible.
If you want to maximize the tax benefits of your vacation home, limit your personal use of the home to no more than 14 days or 10% of the total rental days. If you want to personally use the home more than this, you can still realize some limited tax benefits. Contact our firm for details about your specific situation.
May 2019: Innocent Spouse Rules Offer Protection Under Some Circumstances & Send Your Kids to Day Camp and You May Get a Tax Break
Must one spouse pay the tax resulting from a fabrication or omission by another spouse on a jointly filed tax return? It depends. If the spouse qualifies, he or she may be able to avoid personal tax liability under the “innocent spouse” rules.
Joint filing status
Generally, married taxpayers benefit overall by filing a joint tax return on the federal level. This is particularly the case when one spouse earns significantly more than the other. Filing jointly may also help the couple maximize certain income tax deductions and credits.
But joint filing status comes with a catch. Each spouse is “jointly and severally” responsible for any tax, interest and penalties attributable to the return. And this liability continues to apply even if the couple gets a divorce or one spouse dies. In other words, the IRS may try to collect the full amount due from one spouse, even if all the income reported on the joint return was earned by the other spouse.
However, the tax law provides tax relief for an “innocent spouse.” Under these rules, one spouse may not be liable for any unpaid tax and penalties, despite having signed the joint return.
To determine eligibility for relief, the IRS imposes a set of common requirements. The spouses must have filed a joint return that has an understatement of tax, and that understatement must be attributable to one spouse’s erroneous items. For this purpose, “erroneous items” are defined as any deduction, credit or tax basis incorrectly stated on the return, as well as any income not reported.
From there, the other (“innocent”) spouse must establish that, at the time the joint return was signed, he or she didn’t know — or have reason to know — there was an understatement of tax. Finally, to qualify, the IRS needs to find that it would be unfair to hold one spouse liable for the understatement after considering all the facts and circumstances.
For many years, innocent spouse relief had to be requested within two years after the IRS first began its collection activity against a taxpayer. But, in 2011, the IRS announced that it would no longer apply the two-year limit on collection activities.
In addition, by law, when one spouse applies for innocent spouse relief, the IRS must contact the other spouse or former spouse. There are no exceptions even for victims of spousal abuse or domestic violence.
Historically, courts haven’t been particularly generous about upholding claims under the innocent spouse rules. State laws can also complicate matters. If you’re wondering whether you’d qualify for relief, please contact us for help.
Sidebar: What does the IRS consider?
The IRS considers “all facts and circumstances” in determining whether it would be inequitable to hold an “innocent” spouse liable for taxes due on a jointly filed tax return. One factor that may increase the likelihood of relief is that the taxes owed are clearly attributable to one spouse or an ex-spouse who filled out the errant return.
If one spouse was deserted during the marriage, or suffered abuse, it may also improve the chances that innocent spouse relief will be granted. In some cases, the IRS may examine the couple’s situation to determine whether the spouse applying for relief knew about the erroneous items.
SEND YOUR KIDS TO DAY CAMP AND YOU MAY GET A TAX BREAK
Among the many great challenges of parenthood is what to do with your kids when school lets out. Do you keep them at home and try to captivate their attention yourself or with the help of sitters? Or do you send them off to the wide variety of day camps now in operation? There’s no one-size-fits-all answer, but if you choose the latter option, you might qualify for a tax break!
Day camp — but, to be clear, not overnight camp — is a qualified expense under the child and dependent care tax credit, which is worth 20% of qualifying expenses (more if your adjusted gross income is less than $43,000), subject to a cap. For 2019, the maximum expenses allowed for the credit are $3,000 for one qualifying child and $6,000 for two or more.
Remember that tax credits are particularly valuable because they reduce your tax liability dollar-for-dollar — $1 of tax credit saves you $1 of taxes. This differs from deductions, which simply reduce the amount of income subject to tax. For example, if you’re in the 24% tax bracket, $1 of deduction saves you only $0.24 of taxes. So, it’s important to take maximum advantage of the tax credits available to you.
Qualifying for the credit
A qualifying child is generally a dependent under age 13. (There’s no age limit if the dependent child is unable physically or mentally to care for him- or herself.) Special rules apply if the child’s parents are divorced or separated or if the parents live apart.
Eligible costs for care must be work-related. This means that the child care is needed so that you can work or, if you’re currently unemployed, look for work.
If you participate in an employer-sponsored child and dependent care Flexible Spending Account (FSA), also sometimes referred to as a Dependent Care Assistance Program, you can’t use expenses paid from or reimbursed by the FSA to claim the credit.
Additional rules apply to the child and dependent care credit. If you’re not sure whether you’re eligible, contact us. We can assist you in determining your eligibility for this credit and other tax breaks for parents.
Apr 2019: Business vs Hobby: The Tax Rules Have Changed & Are Income Taxes Taking a Bite Out of Your Trusts?
If you generate income from a passion such as cooking, woodworking, raising animals — or anything else — beware of the tax implications. They’ll vary depending on whether the activity is treated as a hobby or a business.
The bottom line: The income generated by your activity is taxable. But different rules apply to how income and related expenses are reported.
Factors to consider
The IRS has identified several factors that should be considered when making the hobby vs. business distinction. The greater the extent to which these factors apply, the more likely your activity will be deemed a business.
For starters, in the event of an audit, the IRS will examine the time and effort you devote to the activity and whether you depend on income from the activity for your livelihood. Also, the IRS will likely view it as a business if any losses you’ve incurred are because of circumstances beyond your control, or they took place in what could be defined as the start-up phase of a company.
Profitability — past, present and future — is also important. If you change your operational methods to improve profitability, and you can expect future profits from the appreciation of assets used in the activity, the IRS is more likely to view it as a business. The agency may also consider whether you’ve previously made a profit in similar activities. Also, the intent to make a profit is a key factor.
The IRS always stresses that the final determination will be based on all the relevant facts and circumstances related to your activity.
Changes under the TCJA
Under previous tax law, if the activity was deemed a hobby, you could still generally deduct ordinary and necessary expenses associated with it. But you had to deduct hobby expenses as miscellaneous itemized deduction items, so they could be written off only to the extent they exceeded 2% of adjusted gross income (AGI).
All of this has changed under the Tax Cuts and Jobs Act (TCJA). Beginning with the 2018 tax year and running through 2025, the TCJA eliminates write-offs for miscellaneous itemized deduction items previously subject to the 2% of AGI threshold.
Thus, if the activity is a hobby, you won’t be able to deduct expenses associated with it. However, you must still report all income from it. If, instead, the activity is considered a business, you can deduct the expenses associated with it. If the business activity results in a loss, you can deduct the loss from your other income in the same tax year, within certain limits.
An issue to address
Worried the IRS might recharacterize your business as a hobby? Contact our firm. We can help you address this issue on your 2018 return or assist you in perhaps filing an amended return, if appropriate.
ARE INCOME TAXES TAKING A BITE OUT OF YOUR TRUSTS?
If your estate plan includes one or more trusts, review them before you file your tax return. Or, if you’ve already filed it, look carefully at how your trusts were affected. Income taxes often take an unexpected bite out of these asset-protection vehicles.
3 ways to soften the blow
For trusts, there are income thresholds that may trigger the top income tax rate of 37%, the top long-term capital gains rate of 20%, and the net investment income tax of 3.8%. Here are three ways to soften the blow:
1. Use grantor trusts. An intentionally defective grantor trust (IDGT) is designed so that you, the grantor, are treated as the trust’s owner for income tax purposes — even though your contributions to the trust are considered “completed gifts” for estate- and gift-tax purposes.
The trust’s income is taxed to you, so the trust itself avoids taxation. This allows trust assets to grow tax-free, leaving more for your beneficiaries. And it reduces the size of your estate. Further, as the owner, you can sell assets to the trust or engage in other transactions without tax consequences.
Keep in mind that, if your personal income exceeds the applicable thresholds for your filing status, using an IDGT won’t avoid the tax rates described above. Still, the other benefits of these trusts make them attractive.
2. Change your investment strategy. Despite the advantages of grantor trusts, non-grantor trusts are sometimes desirable or necessary. At some point, for example, you may decide to convert a grantor trust to a non-grantor trust to relieve yourself of the burden of paying the trust’s taxes. Also, grantor trusts become non-grantor trusts after the grantor’s death.
One strategy for easing the tax burden on non-grantor trusts is for the trustee to shift investments into tax-exempt or tax-deferred investments.
3. Distribute income. Generally, non-grantor trusts are subject to tax only to the extent they accumulate taxable income. When a trust makes distributions to a beneficiary, it passes along ordinary income (and, in some cases, capital gains), which are taxed at the beneficiary’s marginal rate.
Thus, one strategy for minimizing taxes on trust income is to distribute the income (assuming the trust isn’t already required to distribute income) to beneficiaries in lower tax brackets. The trustee might also consider distributing appreciated assets, rather than cash, to take advantage of a beneficiary’s lower capital gains rate. Of course, doing so may conflict with a trust’s purposes.
Opportunities to reduce
If you’re concerned about income taxes on your trusts, contact us. We can review your estate plan to assess the tax exposure of your trusts, as well as to uncover opportunities to reduce your family’s tax burden.
Feb 2019: Multistate Resident? Watch Out for Double Taxation & Fewer Taxpayers to Qualify for Home Office Deduction
Contrary to popular belief, there’s nothing in the U.S. Constitution or federal law that prohibits multiple states from collecting tax on the same income. Although many states provide tax credits to prevent double taxation, those credits are sometimes unavailable. If you maintain residences in more than one state, here are some points to keep in mind.
Domicile vs. residence
Generally, if you’re “domiciled” in a state, you’re subject to that state’s income tax on your worldwide income. Your domicile isn’t necessarily where you spend most of your time. Rather, it’s the location of your “true, fixed, permanent home” or the place “to which you intend to return whenever absent.” Your domicile doesn’t change — even if you spend little or no time there — until you establish domicile elsewhere.
Residence, on the other hand, is based on the amount of time you spend in a state. You’re a resident if you have a “permanent place of abode” in a state and spend a minimum amount of time there — for example, at least 183 days per year. Many states impose their income taxes on residents’ worldwide income even if they’re domiciled in another state.
Suppose you live in State A and work in State B. Given the length of your commute, you keep an apartment in State B near your office and return to your home in State A only on weekends. State A taxes you as a domiciliary, while State B taxes you as a resident. Neither state offers a credit for taxes paid to another state, so your income is taxed twice.
One possible solution to such double taxation is to avoid maintaining a permanent place of abode in State B. However, State B may still have the power to tax your income from the job in State B because it’s derived from a source within the state. Yet State B wouldn’t be able to tax your income from other sources, such as investments you made in State A.
Minimize unnecessary taxes
This example illustrates just one way double taxation can arise when you divide your time between two or more states. Our firm can research applicable state law and identify ways to minimize exposure to unnecessary taxes.
Sidebar: How to establish domicile
Under the law of each state, tax credits are available only with respect to income taxes that are “properly due” to another state. But, when two states each claim you as a domiciliary, neither believes that taxes are properly due to the other. To avoid double taxation in this situation, you’ll need to demonstrate your intent to abandon your domicile in one state and establish it in the other.
There are various ways to do so. For example, you might obtain a driver’s license and register your car in the new state. You could also open bank accounts in the new state and use your new address for important financially related documents (such as insurance policies, tax returns, passports and wills). Other effective measures may include registering to vote in the new jurisdiction, subscribing to local newspapers and seeing local health care providers. Bear in mind, of course, that laws regarding domicile vary from state to state.
FEWER TAXPAYERS TO QUALIFY FOR HOME OFFICE DEDUCTION
Working from home has become commonplace for people in many jobs. But just because you have a home office space doesn’t mean you can deduct expenses associated with it. Beginning with the 2018 tax year, fewer taxpayers will qualify for the home office deduction. Here’s why.
Changes under the TCJA
For employees, home office expenses used to be a miscellaneous itemized deduction. Way back in 2017, this meant one could enjoy a tax benefit only if these expenses plus other miscellaneous itemized expenses (such as unreimbursed work-related travel, certain professional fees and investment expenses) exceeded 2% of adjusted gross income.
Starting in 2018 and continuing through 2025, however, employees can’t deduct any home office expenses. Why? The Tax Cuts and Jobs Act (TCJA) suspends miscellaneous itemized deductions subject to the 2% floor for this period.
Note: If you’re self-employed, you can still deduct eligible home office expenses against your self-employment income during the 2018 through 2025 period.
Other eligibility requirements
If you’re self-employed, generally your home office must be your principal place of business, though there are exceptions.
Whether you’re an employee or self-employed, the space must be used regularly (not just occasionally) and exclusively for business purposes. If, for example, your home office is also a guest bedroom, or your children do their homework there, you can’t deduct the expenses associated with that space.
If eligible, you have two options for claiming the home office deduction. First, you can deduct a portion of your mortgage interest, property taxes, insurance, utilities and certain other expenses, as well as the depreciation allocable to the office space. This requires calculating, allocating and substantiating actual expenses.
A second approach is to use the simplified option. Here, only one simple calculation is necessary: $5 multiplied by the number of square feet of the office space. The simplified deduction is capped at $1,500 per year, based on a maximum of 300 square feet.
More rules and limits
Be aware that we’ve covered only a few of the rules and limits here. If you think you may qualify for the home office deduction on your 2018 return or would like to know if there’s anything additional you need to do to become eligible, contact us.
Jan 2019: Laying the Groundwork for Your 2018 Tax Return & Installment Sales: A Viable Option for Transferring Assets
The Tax Cuts and Jobs Act (TCJA) made many changes to tax breaks for individuals. Let’s look at some specific areas to review as you lay the groundwork for filing your 2018 return.
For 2018 through 2025, the TCJA suspends personal exemptions. This will substantially increase taxable income for large families. However, enhancements to the standard deduction and child credit, combined with lower tax rates, might mitigate this increase.
Taxpayers can choose to itemize certain deductions on Schedule A or take the standard deduction based on their filing status instead. Itemizing deductions when the total will be larger than the standard deduction saves tax, but it makes filing more complicated.
The TCJA nearly doubles the standard deduction for 2018 to $12,000 for singles and separate filers, $18,000 for heads of households, and $24,000 for joint filers. (These amounts will be adjusted for inflation for 2019 through 2025.)
For some taxpayers, the increased standard deduction could compensate for the elimination of the exemptions, and perhaps even provide some additional tax savings. But for those with many dependents or who itemize deductions, these changes might result in a higher tax bill — depending in part on the extent to which they can benefit from enhancements to the child credit.
Credits can be more powerful than exemptions and deductions because they reduce taxes dollar-for-dollar, rather than just reducing the amount of income subject to tax. For 2018 through 2025, the TCJA doubles the child credit to $2,000 per child under age 17.
The new law also makes the child credit available to more families than in the past. For 2018 through 2025, the credit doesn’t begin to phase out until adjusted gross income exceeds $400,000 for joint filers or $200,000 for all other filers, compared with the 2017 phaseout thresholds of $110,000 for joint filers, $75,000 for singles and heads of households, and $55,000 for marrieds filing separately. The TCJA also includes, for 2018 through 2025, a $500 tax credit for qualifying dependents other than qualifying children.
Assessing the impact
Many factors will influence the impact of the TCJA on your tax liability for 2018 and beyond. For help assessing the impact on your situation, contact us.
INSTALLMENT SALES: A VIABLE OPTION FOR TRANSFERRING ASSETS
Are you considering transferring real estate, a family business or other assets you expect to appreciate dramatically in the future? If so, an installment sale may be a viable option. Its benefits include the ability to freeze asset values for estate tax purposes and remove future appreciation from your taxable estate.
Giving away vs. selling
From an estate planning perspective, if you have a taxable estate it’s usually more advantageous to give property to your children than to sell it to them. By gifting the asset you’ll be depleting your estate and thereby reducing potential estate tax liability, whereas in a sale the proceeds generally will be included in your taxable estate.
But an installment sale may be desirable if you’ve already used up your $11.18 million (for 2018) lifetime gift tax exemption or if your cash flow needs preclude you from giving the property away outright. When you sell property at fair market value to your children or other loved ones rather than gifting it, you avoid gift taxes on the transfer and freeze the property’s value for estate tax purposes as of the sale date. All future appreciation benefits the buyer and won’t be included in your taxable estate.
Because the transaction is structured as a sale rather than a gift, your buyer must have the financial resources to buy the property. But by using an installment note, the buyer can make the payments over time. Ideally, the purchased property will generate enough income to fund these payments.
Advantages and disadvantages
An advantage of an installment sale is that it gives you the flexibility to design a payment schedule that corresponds with the property’s cash flow, as well as with your and your buyer’s financial needs. You can arrange for the payments to increase or decrease over time, or even provide for interest-only payments with an end-of-term balloon payment of the principal.
One disadvantage of an installment sale over strategies that involve gifted property is that you’ll be subject to tax on any capital gains you recognize from the sale. Fortunately, you can spread this tax liability over the term of the installment note. As of this writing, the long-term capital gains rates are 0%, 15% or 20%, depending on the amount of your net long-term capital gains plus your ordinary income.
Also, you’ll have to charge interest on the note and pay ordinary income tax on the interest payments. IRS guidelines provide for a minimum rate of interest that must be paid on the note. On the bright side, any capital gains and ordinary income tax you pay further reduces the size of your taxable estate.
Simple technique, big benefits
An installment sale is an approach worth exploring for business owners, real estate investors and others who have gathered high-value assets. It can help keep a family-owned business in the family or otherwise play an important role in your estate plan.
Bear in mind, however, that this simple technique isn’t right for everyone. Our firm can review your situation and help you determine whether an installment sale is a wise move for you.
We welcome any questions or comments you may have. Feel free to contact us at any time: