Estate planning is something we put off year after year. Lets face it, we all hope we are going to live 100 + years. And deciding what happens to your things after the clock runs out isn’t a priority when you are just trying to get the kids to school, laundry done, meals made, and - oh yeah you 60 + hour work week isn't going to work itself.
So what’s the point in putting your estate plan on the top of your list of things to do? You won’t, at least not until you get a grasp of what these legal tools can do.
I credit Steve Jobs, founder of Apple computers, as the guy who invented the modern personal computer. Mr. Jobs didn’t invent the first computer; that happened decades before. Nor did he invent desktop computers - many people were using primitive versions of the desktop computer while Jobs attended college. Nor did Jobs actually really know anything about technology. So why do I credit him with inventing personal computers?
While Jobs wasn't a “techy”, he had friends in college who were and who had these primitive personal computers. So primitive that the didn't buy them at the store - they made these computers themselves. When Job’s friends showed them their home-made computers, Jobs immediately recognized something no else before had. Jobs visualized how personal computers can benefit everyone, making our lives easier. The challenge for Jobs and Apple laid in how to sell these computers. He had to figure out a way, and estate planning is similar.
The uses of this legal tool are almost infinite. For example, a friend called me the other day asking for advice. Lucky for him, his father-in-law is gifting him a portion of his vacation property. My friend intends to build a small cabin on his new parcel and asked me how to conduct the transaction with the least tax liability possible. “Simple”, I said, “create an estate plan.”
However, I am not referring to my friend creating estate plan, I am referring to his father-in-law. He proceeded to tell me that his father-in-law's estate plan is none of his business, and of course it isn't. But that wasn't my point; let me explain.
When you purchase property the IRS establishes a tax basis. The best way to understand a tax basis is through an example. Suppose you purchase a home in 2021 for $400,000.00. The money used to purchase the home has already been taxed. Your employer withholds taxes from your paycheck and then you use a portion of that paycheck to make mortgage payments. The principal rule for the IRS is it can never tax your income twice.
Now lets say you live in that home for 20 years, and then sell it in 2041 for $800,000.00. When you file your taxes in 2041 you are required to report an income of $400,000.00. The $400,000.00 is derived by taking the selling price, $800,000.000 then subtracting it from the amount that you initially paid, $400,000.00. In this example, the original purchase price is what the IRS calls your tax basis. Had you been taxed for the entire purchase price (assuming a tax rate of 28%) you would have owed the IRS $224,000.00. But by subtracting the basis (the original $400,000.00) your tax liability is $112,000.00. That’s better then $224,000.00, but not great.
When someone gifts you property that you inherit, whatever that persons original basis is, or whatever they originally purchased the property for. But, that's not the case with a proper estate plan. When you inherit land from a deceased loved one, you receive what's called a “step up” basis. A step-up basis increases the original basis to whatever the property value is at the time of your inheritance. So using the same example, lets see how this plays out.
Suppose you didn't purchase the home in 2021, rather your parents did. And in 2041, you parents pass away leaving the house to you. Your basis in the house is now $800,000.00. If you sell the same year, you have $0.00 tax liability!
Turning back to my friend. This is what I told him to do. Have his father-in-law create an irrevocable trust. He would name my friend and his wife as both the trustee and beneficiary of the trust. His father-in-law will then place the property into the trust. When his father-in-law passes away, my friend now receives the property, limiting the tax liability.
This is just one of the many ways having an estate plan can limit tax liability for beneficiaries receiving assets after someone has passed away. If you are interested in establishing your own estate plan, Schedule a Free Consultation or head over to our Estate Planning page to learn more.
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