SF Apartment : March 2018


The State of Your Estate

by John O'Grady

Estate taxes have been reduced again. The exclusion from estate, gift and generation-skipping tax is now $11.2 million per person ($22.4 million for couples). The estate tax rate of 40 percent will apply after the exclusion is used. The federal government will get less estate tax, and the younger generation will inherit more.

But don’t get too excited. Thanks to a political compromise, the new law expires on December 31, 2025, and because the IRS will be receiving far fewer estate tax returns, all returns are likely to be audited.

Consider Clarifying Your Trust Tax Plan

The latest overhaul of the tax laws makes it essential to review formula clauses routinely included in the trust documents for married couples. The formula clauses are keyed to estate tax exemption amounts and approximate asset values. Now that the assumptions have changed, with a dramatically higher estate tax exemption, old formula clauses will often result in unintended beneficiaries inheriting the estate and all the associated family feuds. In some situations, the courts will be required to determine what was truly intended.

Formula clauses can save property tax for the descendants of married couples by maximizing use of the parent-child exclusion from property tax reassessment. For example, in some situations estate planning documents can provide that certain properties can be transferred to a marital trust on the first death of two spouses to minimize property tax reassessments while maintaining the step up in basis for income tax purposes.

Consider that liquidity needs and future economic turmoil could change assumptions about the value of assets. Each individual situation should be analyzed separately to maximize tax savings while taking care of other articulated priorities. Sometimes you must run the numbers to wisely consider your planning options.

In many instances, individual documents can be simplified. It will make sense to keep some of the traditional estate tax planning in place even for those not concerned about paying estate tax. Regardless of the value of your assets, now is the time to ensure you don’t have outdated tax planning in your documents. Outdated tax planning is often worse than no tax planning.

Your estate lawyer should consider using disclaimer language to make the formula clauses optional rather than mandatory, and adding explanatory provisions, caps and floors, and other safeguards such as trust protectors and special trustees to deal with the unknowns of 2018 and beyond.

Estate Planning Is the Work of a Lifetime

Single individuals generally don’t include formula clauses in their trusts and so they usually aren’t concerned about them. But single or married, your estate planning is the work of a lifetime.

Your estate planning documents should be reviewed whenever there is a change in family relations, such as marriage, marital dissolution, or separation; the death of a spouse; changes regarding a child or grandchild (or other beneficiary); birth or adoption of a child; marriage or marital dissolution of a child; death or illness of a child, or the death of a person named in your documents.

Changes in your economic and personal condition could also require a review of your estate planning documents. These changes include a drastic increase or decrease in the value of your assets; a change in your ability (or desire) to obtain life insurance; a change in employment; a change in business interests; and moving outside of California, or acquiring property outside of California. Review may also be required whenever there is a change in state and federal laws concerning income tax, estate and gift tax, property tax, trusts or probate.

This is not an all-inclusive list. Therefore, every three years or so you might want to consider revising your estate plan based on your circumstances at that time.

Give It Away Tax Free While You Can

The annual gift tax exclusion amount increased from $14,000 to $15,000, effective January 1, 2018. Couples can give $30,000 per year to each child, grandchild, and others, free of estate and gift tax. Unlimited additional tax-free gifts can be made for the direct payment to the providers of education (tuition only) and for most medical care. These gifts are not subject to income tax.

Of course, making large gifts can have major unintended emotional and financial impacts that aren’t always positive. Suppose, for instance, the recipient isn’t old enough or mature enough to manage the gift wisely, or perhaps other relatives will be offended because they didn’t receive an equal gift. Blended families have even more to think about in terms of the children and assets of previous marriages.
Now, while the higher exemption amount and lower estate and gift tax rates are in effect, is the time to take advantage of this temporary opportunity to make large gifts to loved ones. It’s also important to make sure your planning documents are up-to-date to protect yourself and your quality of life and end-of-life care.

Many people want to see their buildings stay in the family after their death rather than sold to pay estate tax. There are several steps that can make this a reality. Transferring the property to family members during one’s lifetime, directly or through a grantor trust, is one way to keep your building in the family and avoid estate tax. There can be tax costs associated with lifetime transfers, and they must be planned carefully, but they are an excellent way to keep the government from taxing the future appreciation of the buildings upon your death.
In many cases, good tax planning will include significant lifetime gifts to reduce the taxable estate. Such gifts must be reported on a gift tax return to show a partial use of the donor’s $11.2 million lifetime exclusion amount, although there will be no tax due with the return if some of the $11.2 million lifetime exclusion is still available. Please keep in mind that this discussion only concerns transfer taxes and not income tax. Gifts and inheritances are not generally subject to income tax.

Step-up in Basis Rules Unchanged

For now, the “step-up” in basis rules have not changed. This means that the cost basis of inherited property will continue to be the date-of-death value and not what the decedent paid for the property. Inherited property can be sold shortly after death with little or no income tax consequences. Many older adults and their families will continue to avoid selling the property during the lifetime of the older generation to save on business income taxes.

Profitable Building Owners Win Big

Landlords are among the biggest winners under the new federal tax law. It provides a new tax deduction for individuals with rental income. If your rental activity qualifies as a business for tax purposes (which it most likely does), you may be eligible to deduct 20 percent of your rental income. This is in addition to all your other rental-related deductions.

You qualify for this deduction if you operate your rental business as a sole proprietor, LLC owner, partner in a partnership, or S corporation and your total taxable income for the year from all sources after deductions is below $315,000 for couples and $157,500 for individuals. For those making more than these amounts, Congress created a deduction that is tied to W-2 employee wages and the cost of the real property you rent. Please consult your tax accountant to take advantage of the new tax law. The law expires December 31, 2025.
Triple-net leases are excluded from this tax-saving opportunity. With a triple-net lease, tenants agree to pay the big ticket items like property taxes, insurance and maintenance. Consider contacting your attorney to renegotiate triple-net leases to get the tax deduction with minimal modification of the economic terms with your tenants.

New Opportunities for the Little Ones 

Under the new law, large sums of money may be invested in a 529 plan, which will grow tax-free like an IRA, for religious and private education (beginning with elementary school, not only for college).

In the past, very few financial institutions made 529 plans available. We expect many more offerings to appear because of the expanded purpose of these educational savings plans. When estate planning includes children’s future education, ensure that guardianship documents are in order.

Life Insurance Trusts

Many property owners bought life insurance so that buildings wouldn’t have to be sold after the owner’s death to pay estate tax. Life insurance is not a good investment compared to San Francisco real estate. Consider selling unwanted life insurance policies and putting the money to better use.

Review Your Plan with a Qualified Estate Planning Lawyer

An estate plan is only a plan. Plans are made to be changed, and you may amend your estate plan if you are alive and mentally competent. Review all your estate planning documents (including your will, trust, power of attorney and beneficiary designations, and advance health care directive) every three to five years and after any major life event (such as marriage, divorce, birth, death, significant change in financial situation, move or change in property ownership).

Wills and trust documents are executed with certain formalities and may be changed or revoked only through similar procedures. Making a note in the margin of your document or striking out words (even next to your signature) may not be effective and are likely to cause uncertainty and litigation among your loved ones.

A professional, qualified estate planning lawyer can provide invaluable help as you navigate the often complex and challenging estate planning process. But it’s your own smarts and attention to financial affairs that will ultimately determine how the final act of your life story plays out. The main lesson to remember is that you are ultimately in charge of your own estate. You’re the author of your own life and death. Ensure that your hard-earned rental properties are well managed during your lifetime and beyond to spare your loved ones from engaging in unnecessary, expensive and painful disputes in both the living room and the courtroom.

John O’Grady leads O’Grady Law Group, a full-service estate and trust law firm in San Francisco. He’s been promoting family leadership of building owners with trust and other estate planning documents for more than 25 years. He served as the 2012 Chair of The Estate Planning, Trust and Probate Section of the Bar Association of San Francisco. His practice includes Estate Planning and Administration, Probate and Trust Litigation, Collaborative Practice, Mediation, Conflict Coaching, Elder Law and Taxation.