CAPITAL GAINS TAX: The Top 10 Current Issues and Planning Opportunities

The rise in capital gains tax rates and the higher federal estate tax exemption have shifted the estate planning paradigm. Across the nation, long-term capital gains tax rates now range from 25% to 33%, with the combination of the top federal, state and local rates, along with the Medicare surtax. This demands a fresh look at current planning strategies.

When assets are included in an estate, they are subject to estate tax, but the assets enjoy a step-up in basis for income-tax purposes. Gains tax can then be avoided. However, if there is no estate tax because the gross estate assets are below the estate tax exemption amount, then it may make sense to keep assets inside the estate.

Many estate planning attorneys have spent the first half of their careers getting assets out of their clients’ estates, but now they might spend the second half of their careers getting assets back into their clients’ estates (for those individual estates under $5.43MM or joint estates under about $11MM).

As part of McManus & Associates’ Educational Conference Call series, John O. McManus this month examined how to shift gears in light of new, unique opportunities. We invite you to listen to the recording to find detailed information on the Top 10 issues and planning opportunities related to capital gains tax.

LISTEN HERE: “Top 10 Current Issues and Planning Opportunities with Capital Gains Tax”

  1. The Basics of Basis. Cost basis is the original acquisition value of an asset for tax purposes (usually the purchase price or the inherited price), adjusted for stock splits, dividends and return of capital distributions. This original value is used to determine the capital gain – and becomes the difference between the asset’s cost basis and the current market value.
    1. Assets with a high basis include cash (which actually has no basis) and recently purchased assets that have not yet appreciated.
    2. Assets with a low basis include Exxon stock your grandfather gave to you and a Brooklyn brownstone purchased in the ‘60’s that have significantly appreciated.
  2. Striking while the Step-Up’s Hot. A step-up in basis is the readjustment of the value of an appreciated asset for tax purposes. With a step-up in basis, the value of the asset is determined to be the higher market value of the asset at the time of transfer, not the value at which the original party purchased the asset.
    1. When an asset is gifted to an individual or to a trust, there is a carryover of the original basis – meaning there is no step-up in basis. Although the asset is now outside the grantor’s estate for estate tax purposes, upon the sale of the asset, there will be capital gains tax to be paid.
    2. When an asset is included in a decedent’s estate, the asset receives a step-up in basis to the date of death value at that time. The asset can be sold to avoid any capital gains tax.
  3. Transfer Up to Get Capital Gains Down. Transferring an asset “upstream” to your parents or a trust for the benefit of your parents will enable the asset to get a step–up in basis upon the parents’ death.
    1. At that time, the parents would leave the asset back to the client or the client’s descendants in trust, and the asset could then be liquidated free of capital gains tax.
    2. Don’t forget that you use part of your lifetime exemption based on the value of the upstream gift.
  4. Remember the Second Half of Estate Planning Attorneys’ Careers? Assets previously gifted by clients directly to family members or in trust for estate tax minimization purposes may have appreciated significantly, causing unintended capital gains tax consequences for their loved ones.
    1. With the current $5.43MM federal estate tax exemption, clients may no longer have exposure to estate taxes. Thus, they may consider intentionally undermining the prior gifting plan to cause the asset to be included in their estate, achieving the step-up in basis on death.
    2. If we prepared your trust, we provided an asset substitution provision, which allows you to swap low basis assets out of the trust back into the estate. This would allow a step-up in basis upon death.
  5. Speeding up the Process when You Want to Sell Now. For older clients who wish to sell highly appreciated assets in the near-term, several trust strategies can provide the benefit of a step-up in basis upon the passing of the first spouse.
    1. For jointly held assets, if the surviving spouse were to sell after the first spouse’s passing, the survivor would still owe capital gains tax on his or her remaining 50% interest in the asset.
    2. Community Property Trusts with a situs in Alaska or Tennessee, Joint-Exempt Step-Up Trusts (JEST), and Estate Trusts are all planning vehicles that are structured to allow for the surviving spouse to sell an appreciated asset without the imposition of any capital gains tax after the first spouse’s death. Make certain that there is a separate side agreement that the property is treated as community property
  6. Tinkering with the Taxation of Capital Gains in a Trust. For non-grantor trusts, long-term capital gains are not included in distributable net income (DNI) and are taxed at the top marginal rate.
    1. The trust itself may allow for the trustee to have discretionary powers to distribute principal, as well as the power to shift capital gains to income for inclusion in DNI.
    2. An alternate for the power to adjust is the use of the state unitrust statute. A unitrust generally allows a fiduciary to calculate the trust’s income as a percentage of the trust’s assets, as of either the beginning of the year or averaged over some period (NY provides for unitrusts while NJ does not).
    3. However, NJ does allow for a safe harbor power to adjust; a trustee is permitted to adjust the distribution to the income beneficiary (from 3%-5% of the FMV of the trust’s assets in any accounting period). This adjustment must be deemed to be responsible and fair to all of the trust’s beneficiaries.
    4. If possible, utilize a grantor trust and have all income, deductions, and credits, including capital gains, taxed to the grantor at a presumably lower individual income tax rate.
    5. Consider switching the situs of the trust to a state that does not have state gains tax.
  7. Spending Time to Save Money. You may be able to exclude some or all of the gain that is taxed on the sale of your principal residence. The  tax code permits owners of homes to exclude up to $250,000 of capital gain ($500,000 for a married couple) if they have owned and lived in their home for at least two years out of the five years before a sale.
    1. Find better assets to gift than your personal residence.
    2. If you receive a house as a gift and then reside in it as your primary residence for two years, you may be able to reduce or eliminate the capital gains tax on the carryover basis.
  8. The IRS’s Gift for Giving Back. When gifts of appreciated long-term assets are made to charity, no capital gains taxes are owed, because the securities are donated, not sold.
    1. The deduction is limited to 30% of your adjusted gross income (AGI) instead of the usual 50% limit for donations of cash and short-term property made to public charities—though you can still carry forward unused deductions for five years.
    2. If you choose to deduct your cost basis only, you can raise the limit to 50% of your AGI. But if you’re holding securities with a loss, it’s better to sell first, take the capital loss for tax purposes, and then donate the cash.
    3. A Charitable Remainder Trust and a Private Operating Foundation may provide similar relief from capital gains tax.
  9. The 411 on a 1031 Exchange. A 1031 Exchange is a way to delay capital gains taxation by rolling the sale proceeds of the original asset into a new investment in a like-kind asset.
    1. This is traditionally used as a strategy for real estate, but it also works for artwork.
    2. The new investment takes the original basis, which is carried over based on the original basis of the asset.
    3. If the owner dies with the asset in his estate, there is a step-up in basis with little to no capital gain upon sale soon thereafter.
  10. Consider the Tax-Free Possibilities. Two special savings accounts are given a pass by the IRS in terms of taxation.
    1. Contributions to a Roth IRA are after-tax and, as such, all future growth and distributions are tax-free.
    2. Contributions to a 529 College Savings Account also grow tax-free and withdrawals for educational expenses are tax-free.