An Educational Discussion Of The Estate Tax, The Gift Tax And The Capital Gains Tax
• By Tiffany Dowell Lashmet,
Texas A&M AgriLife •
Disclaimers: The first is that I am not a certified public accountant or an accountant. I’m here to offer just basic information but highly recommend that you consult with your attorney and tax professional for further advice or clarification. Second, there has been a lot of talk from Washington, D.C., about potential changes to some of these rules.
The information in this Talking Taxes series will explain the law as it currently is written and applied, but everyone needs to be sure to pay attention to any changes that could be forthcoming.
Estate Tax
The first topic of discussion is the federal estate tax.
► What is it? The estate tax, sometimes called the “death tax,” is a federal tax imposed when a person dies and transfers assets to someone other than a surviving spouse. It is essentially a tax on the right to pass assets to another person. Texas does not have a state-level estate tax, but some other states do.
► Who pays it? When the fair market value of the estate is worth more than the recognized exemption, the estate tax is owed. For 2021, the estate tax exemption is $11.7 million per person. This means that if the person’s estate is not valued at more than $11.7 million, no estate tax will be owed.
Note it is the fair market value of the estate at the time of the person’s death that is used in the estate tax calculation. The cost basis (price paid for an asset in the past) is irrelevant.
► How long will the $11.7 million exemption be in place? This really is the magic question. Here’s the breakdown. Every year, the exemption amount is adjusted slightly for inflation. For example, it increased from $11.58 million in 2020 to $11.7 million in 2021. Current law has this $10 million (adjusted for inflation) value set to remain in place through 2025, at which point it will sunset back to the prior $5 million (adjusted for inflation) per person.
To throw more uncertainty into the mix, keep in mind that this exemption amount can be modified by Congress. While it is currently set through 2025, Congress could modify that amount.
► How is the estate tax calculated? If a person’s estate value is over the exemption amount, the tax liability will be 40%. For example, if a person died today with an estate valued at $12.7 million they left to their children, their estate tax liability would be $400,000. ($1 million x 40% = $400,000).
► When is the estate tax due? If owed, the estate tax is generally due within nine months of the death.
► What exemptions exist? There are certain exemptions from the estate tax.
First, any property left to a surviving spouse is not subject to the estate tax. This is due to the unlimited marital deduction, which allows unlimited assets to be passed to the surviving spouse with no estate tax liability. Keep in mind, however, that at the death of the second spouse, his or her estate would be left to someone else and would be subject to the estate tax if over the exemption amount.
One additional note is that the law allows for portability between spouses. This allows the first deceased spouse to port over any unused portion of his or her estate tax exemption to the surviving spouse, thereby increasing the surviving spouse’s exemption.
For example, assume that the wife died in 2021 and used $1 million of her exemption. Portability would allow her to port her remaining $10.7 million over to her surviving spouse, which would then increase his exemption from $11.7 to $22.4 million. ($11.7 million + $10.7 million). To qualify for portability, the estate’s representative must file a Form 706 (estate tax return) within nine months of the death.
Second, there are certain deductions that may be taken from the gross value of one’s estate for estate tax purposes, including mortgages and other debts, estate administrations and property left to qualified charities.
► What can a person do to avoid estate tax liability? There can be a number of options that a person can consider to avoid estate tax liability. The key, of course, is that this must be done prior to the person’s death for them to be effective. Anyone who thinks they could potentially have an estate tax issue should contact an attorney, accountant and/or other tax professional to see what steps might be best for their situation.
► Where can I find additional information? For additional information on the estate tax, check out this podcast episode I did with Kitt Tovar from the Iowa State Center for Agriculture Law and Taxation — https://bit.ly/3gmsWjJ. Additionally, the Internal Revenue Service has some useful explanations on its website, including overviews and frequently asked questions. Go to https://bit.ly/2XIzd2S.
► What potential changes have been discussed? Regarding the estate tax, there have been rumblings that the Biden administration may look to lower the lifetime exemption from the current $11.7 million per person to something far lower, such as $3.5 million/person. This was not included in the American Families Plan that was recently released.
Gift Tax
The next topic is the federal gift tax.
► What is it? The gift tax is a federal tax on asset transfers for less than fair market value. In other words, if you give an asset to someone or if you sell an asset and less than full consideration is paid, it is considered a gift subject to the gift tax.
► Who pays it? Generally, the donor (person giving the gift) is responsible for the gift tax if it is owed.
► How is the gift tax calculated? The gift tax rates range between 18% to 40% depending on the value of the taxable gift. However, most people will not actually pay that amount due to the annual exclusion and the lifetime exclusion.
► What is the annual exclusion? The annual exclusion is an amount below which the gift tax does not apply. Each year, the IRS sets an annual exclusion amount, and any gifts from one person to another falling below that exclusion are not subject to the gift tax. For 2021, the annual exclusion is $15,000.
Importantly, the annual exclusion applies to each donee (gift recipient). This means that a person may give any other individual up to $15,000 in 2021 without gift tax implications. For example, a mother could give each of her four sons and each of their wives $15,000 this year without being subject to the gift tax even though the total amount gifted was $120,000.
► What is the lifetime exclusion? The lifetime exclusion is a concept discussed in the estate tax section. For 2021, every person has an $11.7 million lifetime exemption. If a person makes a gift this year to another person worth more than $15,000, they are required to file a gift tax return. The gift giver will not, however, automatically owe the gift tax. Instead, the amount over the annual exclusion will be deducted from your lifetime exemption.
For example, if you give your child a gift of $25,000 in 2021, this is considered a taxable gift because it exceeds the annual exclusion. Because of that, you will have to file a gift tax return, and the $10,000 that exceeds the annual exclusion will be deducted from your lifetime exclusion. No gift tax will actually be paid until the lifetime exclusion has been exhausted.
► When is the gift tax return due? Anyone who makes a taxable gift (one exceeding the $15,000 annual exclusion) must file a gift tax return (Form 709) by the normal tax filing deadline the year after the gift is made. Note, this gift tax return is required for any taxable gift, even if the lifetime exclusion has not been exhausted and even if no taxes are actually owed.
► What exemptions exist? There are certain gifts excluded from the gift tax.
First, as discussed above, any gift worth less than the annual exclusion is not subject to the gift tax.
Second, there are educational and medical exclusions that may be available for a person paying school tuition or medical expenses for another person. There are particular requirements here, including that the person giving the gift must pay the school or medical facility directly. If this may be applicable to you, contact your accountant to ensure all requirements are met.
Third, any gifts made to one’s spouse are excluded from gift tax liability.
Fourth, gifts to political organizations are excluded.
Finally, gifts given to qualifying charities are deductible from the value of the gift made.
► What can a person do to avoid gift tax liability? There can be options to consider to avoid gift tax liability. Before making gifts over the annual exclusion, a person should visit with his or her attorney, account and/or tax professional to discuss other strategies.
► How can a person’s gift tax affect their estate tax liability? This is a key point for people to understand. If a person gives taxable gifts during his or her lifetime, that directly affects the amount of his or her lifetime exclusion. Keep in mind, it is the value of that lifetime exclusion that dictates whether a person owes the estate tax or not.
This is a connection that may not seem obvious but could have major unintended consequences. For example, say that Pat has an estate worth $10 million. He does not worry about the estate tax, because he is below the $11.7 million lifetime exemption.
However, if Pat gifted land worth $2,015,000, he could have an estate tax problem. This is because Pat made a taxable gift that was $2 million over the annual exclusion. Thus, his lifetime exemption will be reduced by that $2 million, leaving him with $9.7 million. Because his estate is worth more than the lifetime exemption, he will owe estate tax.
► Where can I find additional information? For additional information about the gift tax, the IRS has some useful explanations on its website at https://bit.ly/3gjSPRr, including overviews and frequently asked questions.
Capital Gains Tax
The final topic for discussion is the federal capital gains tax.
► What are they? Capital gains taxes are a tax due when a person sells an asset that has appreciated in value. For example, if a person purchased land that cost $400 per acre, and she sells it years later for $1,000 per acre, capital gains taxes would be owed on the $600/acre increase in value that has occurred since the time she acquired the land. Capital gains taxes only apply to “capital assets” such as stocks, bonds, jewelry, collectibles, artwork, vehicles and land.
► Who pays it? Generally, the seller is responsible for paying the capital gains taxes owed. Note that capital gains taxes are only “realized” or owed when the asset is sold. If a person does not sell an asset, these taxes are not realized, no matter how much the value may increase.
► How are capital gains taxes calculated? Capital gains taxes are broken into long-term capital gains and short-term capital gains. Long-term capital gains are owed on assets held for over one year. Long-term gains rates range from 0% to 20%, depending on a person’s tax bracket. Short-term capital gains are owed on assets held for less than one year.
Short-term gains are taxed as ordinary income.
Keep in mind that capital gains for a year may also be offset by capital losses for the same year. Capital losses occur when a person sells an asset for less than he or she paid for it. Say a person purchased Stock A and Stock B, each for $100. Two years later, the person sells Stock A for $150 and Stock B for $50. The person’s net capital gain would be zero, and no capital gains taxes would be due for these stocks.
Note that the cost basis can be adjusted up or down depending on certain situations. For example, if improvements are made to a capital asset, thereby increasing the value, the cost basis may also increase.
Conversely, if a person depreciates an asset, that may decrease the cost basis for the asset as well. There are numerous specific details to consider here that are beyond the scope of this article, so again, I recommend seeking advice from a licensed professional.
► When are capital gains taxes due? Capital gains taxes are due by the normal tax deadline in the year following the sale of an asset.
► What exemptions exist? There are certain exemptions to capital gains taxes. Here are a couple of key ones to consider.
First, a person’s primary home is considered a capital asset, but the IRS recognizes an exclusion on capital gains earned through the sale of a primary residence. The exclusion is $500,000 for couples filing jointly and $250,000 for a person filing as single.
Second, there are certain retirement plans such as 401(k)s, 403(b)s, Roth IRAs and traditional IRAs that grow without being subject to capital gains taxes. This allows a person to buy and sell within a retirement plan without paying capital gains taxes.
Third, business inventory and depreciable business property is not subject to capital gains taxes.
► What is a stepped up basis? One key concept related to capital gains taxes is that of a stepped up basis. This is particularly important for agricultural operations that have been passed from one generation to the next. If a step up in basis is allowed, it changes the cost basis for an asset.
Say Mom purchased her land for $500 per acre. When she died and left the land to her son in her will, it was worth $1,000 per acre. The step up in basis would allow the cost basis for the land to increase from $500 to $1,000 when it was inherited by the son. Thus, if he sells the land and it is worth $1,500, he will owe capital gains taxes on $500 ($1,500 – $1000), rather than on $1,000 ($1,500 – $500).
Importantly, with regard to transferring an asset at death, only those assets that are transferred at death, such as by will, by transfer on death deed, or by Lady Bird deed, for example, will qualify for the step up in basis. If the asset was transferred prior to death, there would be no stepped up basis allowed. To read more about the pros and cons of transferring property before death, visit https://bit.ly/3gjKWuW.
► What can be done to avoid capital gains tax liability? There are options for a person to avoid capital gains tax liability, but a person should consult with an attorney, accountant and/or tax professional before selling an asset to fully explore these options. Regarding real property, one may be a 1031 exchange, if the seller wishes to purchase like kind property with the proceeds from the sale.
It is important to remember, however, that a 1031 Exchange does not completely eliminate the requirement to pay capital gains tax; rather, use of a 1031 exchange enables a person to defer the tax liability from the sale of real property, until the new like kind property acquired in the exchange is later sold.
► Where can I find more information? For more information, listen to this prior podcast episode I did with Pat Dillon — https://bit.ly/3y2SuZd. (Disclaimer — the audio quality was not the best, so I apologize, but the information is useful!)
► What potential changes have been discussed? Recently, capital gains taxes have been in the news as modifications have been mentioned by President Biden and included in his American Families Plan. According to the White House summary of the American Families Plan (https://bit.ly/3D7y30Q), the capital gains tax rate would increase to 39.6% for households making over $1 million. The plan would also eliminate the stepped up basis for gains in excess of $1 million.
The plan contains the following language, “The reform will be designed with protections so that family-owned businesses and farms will not have to pay taxes when given to heirs to continue to run the business.” T
here also has been discussion of taxing unrealized gains at death, as opposed to only actual gains being realized when property is sold. This is an important topic, especially for agriculture, so keeping an eye on any forthcoming changes will be critical.
Tiffany Dowell Lashmet is an associate professor and Extension specialist in agricultural law with Texas A&M AgriLife Extension. Visit her Texas Agriculture Law Blog at https://agecoext.tamu.edu/resources/texas-agriculture-law-blog/. Contact Lashmet at tdowell@tamu.edu or 806-677-5681.