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—referred to as a “capital asset.”. When you sell an asset that has appreciated, the capital gain is defined as the difference between the “cost basis” (what it cost you to acquire the asset) and the selling price.
For example, if you purchase a home for $400,000 and later sell it for $550,000, the $150,000 is a “realized gain” and is 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 (a structural change that adds value) you make to real estate increase the cost basis and the higher figure is then used when calculating the realized gain.
The “personal residence exclusion” allows homeowners who have owned and occupied 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 ordinary income.
However, the basic idea is that if you liquidate an asset that has appreciatedin value, 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 owns real estate — 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 to reduce the size of the estate and the corresponding estate tax.
When considering the options, you need to understand another capital gains tax term: “carry over basis.”
If you gift or transfer a capital asset to someone (either real estate or some other valuable such as stocks), and the recipient of the gift sells it, your original cost basis applies in determining the capital gains tax.
For instance, if you purchase stock for $100,000, gift it to your children after it has appreciated to $200,000, and then your children sells it for $200,000 — they would have to pay a capital gains tax on the $100,000 difference between your original basis and the sales price.
On the other hand, if one of your children inherit the stock upon your death, they may be able to avoid most or all of the capital gains tax because of something called a “step up” in cost basis. This means that if your children inherit a capital asset (rather than receiving it as a gift), the cost basis “steps up” from what the decedent originally paid for it to the value of the asset at the time of death. The children would only pay a capital gains tax when they sell the stock on the appreciation from the date-of-death value.
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 usually neither.
— 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.
If you gift the house to your children, one of them could pass away, leaving the property to a spouse; or someone could be sued, subjecting the home to attachment by your child’s creditors. There is also the risk of Medicaid ineligibility if you enter a nursing home within five years of the date of the gift (referred to as the “look back period”), forcing your children to return the home to you. . On the other hand, holding on to your home would save your children capital gains taxes (because of the stepped-up cost 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 children avoid undue estate and capital gains taxes.
The best way to do this is through a specialized irrevocable trust. By transferring your home or other asset into a carefully designed irrevocable 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 tax because of the stepped-up cost 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 a qualified 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.