Pitfalls at the Intersection of Income & Estate Tax: Planning for Real Estate

Baker Newman Noyes Tax Principal Jean McDevitt recently joined MEREDA members for breakfast to present factors that must be taken into consideration for real estate owners when it comes to both income tax planning and estate tax planning.  Read on to learn what these considerations are and how they don’t often go hand in hand.

No one wants to pay tax, or certainly not any more than they absolutely have to pay!  What many individuals don’t consider is that sometimes it’s better to pay taxes now to save even more taxes later or that what might make sense from an estate tax planning perspective may not make sense with regard to income taxes. In 2014, the maximum federal individual income tax rate is 39.6% and the maximum long term capital gains tax rate is 20%, while the federal estate tax rate is 40%!  However, just because the rates may be lower doesn’t mean that a course of action is immediately clear. There are many other factors to consider.

Real estate owners should assess each asset and its attributes.  Some attributes to consider are:

• Tax Basis
• Fair Market Value
• Ease of Management
• Leveraged Basis

Taxpayers with real estate assets that have very little tax basis but relatively high fair market values may not want to remove these assets from their estates.  Instead, they may wish to hold them until date of death so their beneficiaries benefit from the step up to fair market value, potentially avoiding both income and estate taxes.

Encumbered assets also require careful consideration because the debt affects the fair market value for estate planning purposes but does not impact income tax.  For example, a taxpayer owns a building that is appraised for $1 million.  The building is almost fully depreciated and has a tax basis of only $50,000.  The building also has a mortgage of $800,000.  Assuming the taxpayer has additional assets in excess of the $5.34 million federal estate tax exclusion, his estate will incur $80,000 of estate tax on his death relating to this asset ($1 million value less $800k debt multiplied by 40% estate tax rate).  The beneficiaries of the taxpayer’s estate will now have a $1 million basis so if they in turn sell the building for $1 million, they can pay off the debt, pay the estate tax, and pocket $120,000, paying income tax of $-0-. 

Alternatively, if the taxpayer had sold the building immediately prior to his death, he would have been in a negative cash position.  After paying off the mortgage, the taxpayer would have $200,000 left to pay the taxes relating to the sale. However, the gain on the sale would be taxed at a variety of different rates but assuming a conservative blended federal rate of 25%, he would have incurred income taxes of $237,500 on the $950,000 gain creating a cash shortfall of $37,500! 

Proper guidance can allow taxpayers to match the assets within their portfolios with the proper estate planning techniques, whether simple or complex, to ensure the taxpayers’ wishes are fulfilled and that the assets will be transferred at the lowest tax rates possible.  While the increased federal estate tax exemption has reduced the number of estates that will be subject to the estate tax, it has also increased and improved options available to planners to successfully transfer wealth for individuals, including those whose total assets exceed the exclusion amount.