Will Stepping-Up The Basis of Assets Become More Important Than Avoiding Estate Tax?

Trends come and go and taxation is no different. The change in 2001 to raise the estate tax exemption, now $5,340,000, and to lower the top estate tax rate, now 40%, shifted the emphasis in estate tax planning. The combined estates of most American couples will remain below $10,680,000, so estate tax is no longer a factor for these taxpayers. Recent changes in individual tax rates has caused another shift. Individual tax rates for capital gains were 15% rate in 2001; however, today capital gains are now taxed at 23.8% before state income taxes are considered. Although it is easier to avoid estate tax with the higher exemption, the heirs may lose 8% more on a sale of the asset. Planning for the multiple generations requires consideration of stepping up the basis of assets.

The plan, for individuals who do not reside in New Jersey and whose state death tax law tracks the federal exemption, is to hold assets until death and step-up their basis. In New Jersey, this strategy attracts a state death tax because the state exemption is only $675,000. Assume a combined estate at the first death of $2,775,000, where $675,000 is placed in a bypass or credit shelter trust at the first death and $2,100,000 remains in the hands of the surviving spouse. At the second death in New Jersey, $106,800 of New Jersey estate tax would become due; however, the assets would receive a step-up in basis and could be sold by the estate or heirs without income tax. If that same couple resided in Florida, there may be no estate or income tax.

Assume the assets of the bypass trust grew in value to $1,000,000, there would be no New Jersey estate tax to pay on the incremental growth. The $325,000, if taxed in the survivor’s estate, would attract an 8% tax or an additional $26,000. Notwithstanding, $325,000 of gain subject to state and federal income tax at a combined rate of consisting of 29.325%, 23.8% federal and 5.525% state using individual, not trust, tax rates. The strategy to save New Jersey estate tax of $26,000 costs $95,306 income tax.

If the assets, consisting of the $2,775,000 combined estate plus the hypothetical appreciation of $325,000 were held by the surviving spouse until death and reported in the taxable estate, the basis of assets would be fair market value and there would be no income tax on a sale shortly after death. The New Jersey estate tax on $3.1m would be $190,800. Compare that figure to $202,106, comprised of $95,306 of income tax and $106,800 of New Jersey estate tax.

The analysis ignores the ability of the second spouse to relocate to Florida, for example, and hold all of the assets until death.   The example points out that trusts need to be more flexible, a topic to be covered in the next blog.

If you or someone you know is being harrassed over their taxes, check out the Scarinci Hollenbeck Tax Video Series: Are You Overassessed? on businesslawnews.com.