Most people are aware that there are steps you should consider to protect your assets from being liquidated to pay for long-term care. And to protect your heirs from the burden of heavy estate taxes upon your passing. However, are you aware of the related risks associated with the capital gains tax?
What is the capital gains tax?
The capital gains tax is levied on the profit you earn from the sale of an investment or property. When you sell an asset that has appreciated, the capital gain is defined as the difference between the “basis” (what it cost you to acquire the asset) and the selling price.
For example, if you purchased a home for $400,000 and later sold it for $550,000, the $150,000 would be considered a “realized gain” and would be taxable as income.
This is, of course, an over-simplified example, and there are many variables and exceptions to consider in a real-world case. For instance:
Any capital improvements you make on a property increase the basis and the higher figure is then used when calculating the realized gain.
The “personal residence exclusion” allows homeowners who have lived in a home for at least 2 of the 5 years leading up to a sale to exclude up to $250,000 of the capital gain from the sale. And, in some cases in which spouses file jointly, that amount may increase to $500,000.
There are also variances in which tax rate applies; it’s usually a lower rate than for regular income.
However, the basic idea is that if an asset appreciates and you liquidate that asset, you will pay capital gains tax on your profits.
How does the capital gains tax come into play in estate planning?
One of the most common estate planning scenarios involving capital gains is when a parent has a real estate asset — usually a home — that they
- Don’t want to lose in the course of paying for long-term care, and/or
- Think should be transferred to the children in order to reduce the value of the estate and the corresponding estate tax.
When considering the options, you need to understand another capital gains term: “carry over basis.”
If you gift or transfer an asset to someone (either real estate or some other valuable such as stocks), and they sell it, your original basis value applies.
So, if you acquired the asset for $100,000, gifted it to someone once it had appreciated in value to $200,000, and then that person sold it for $200,000 — they would have to pay capital gains on the $100,000 difference between your original basis and their sell price, even though there was technically no profit since the asset’s value was equal to the sale price.
On the other hand, if one of your heirs inherits that asset upon your death, they may be able to avoid much if not all of the capital gains tax because of something called a “step up” in basis. All this means is that when someone inherits an asset (rather then receiving it as a gift), the basis “steps up” from what the decedent originally paid for it to the value of the asset at the time of death.
What’s the best way to protect assets and mitigate capital gains tax?
Having read about the two approaches above, you might be asking yourself whether it’s wiser to transfer ownership of an asset, typically a home, or leave it to your heirs in your Will. The answer is none of the above.
— Transferring a home to your children may seem like a simple solution, but if you purchased your home years ago, they will likely have to pay a substantial capital gains tax if they choose to sell it.
— Gifting your home can also create unnecessary risks. The person you gift the house to could pass away, leaving the property to a spouse; or you could suffer a stroke before the five-year look back period is past, forcing you to take the house back to avoid facing a Medicaid ineligibility penalty. Likewise, holding on to your home would save your heirs capital gains tax (because of the stepped up basis), but if you need long-term care, you may be forced to sell the house anyway.
Your best option
While there are clearly some tax benefits to each option, there is a smarter way to both protect your assets from going to a nursing home and help your heirs avoid undue estate and capital gains taxes.
The best way to do this is through a specialized trust. By placing your home or other asset into a carefully designed trust, you can ensure that those assets are not counted as part of your estate. This will protect the assets from liquidation to pay for long-term care because it won’t be considered part of your estate, and it will relieve your heirs of the capital gains burden because of the stepped up basis that will apply upon your death.
It is important, since the 5-year look back period will apply to any such trust, to work with your estate planning attorney to make your plans well in advance of any potential crisis that may arise. By looking ahead proactively and working with an expert in estate planning law, you will be able to ensure that you get the most out of your assets, protect them, and create the best possible financial outcome for your heirs.
Give us a call, we can help you make sense of all of this and let you know if a trust is right for you.