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Unconventional Estate Planning Strategies That Can Save A Bundle In Income Taxes

Some time ago, an orthodontic client transferred his office building into his father’s name, in order to provide retirement income for him on a tax-deductible basis. A few years later the father died, leaving a modest estate, well short of the federal estate tax limit. Under his will, the father left the office building back to his son, our orthodontic client. In preparing the estate tax return, the attorney involved “low-balled” the building’s value at only $300,000, when, in fact, it’s true value was closer to $600,000.

All was well until the orthodontist moved into new office space a few years later, and sold the inherited office building. The doctor’s CPA advised that he would owe approximately $75,000 in federal and state income taxes on the $300,000 gain from the sale ($600,000 selling price less $300,000 basis as reported on his father’s death tax return).

The client requested that we review his tax return prior to filing to see if something could be done to reduce the taxes due. Since only a few short years had passed between the time of the father’s death and the sale of the office building, it was clear that the $300,000 estate tax value did not reflect the true fair market value of the building at the time of his father’s death. We had a local real estate appraiser go back and appraise the value of the property as of the date of the doctor’s father’s death. The appraisal determined that the true value at that time was approximately $550,000. The estate tax returns were amended to correct the value of the office building, resulting in no additional death taxes due. However, increasing the building’s value at the father’s date of death had a huge impact on his son’s income taxes on the building sale. That’s because most assets included in an estate received a “stepped up” basis for future income tax purposes, equal to their fair market value at the date of death. Through increasing the basis on the office building at sale from $300,000 to $550,000, the doctor was able to shave $62,500 off of his federal and state income taxes!

This case highlights a common error made in connection with end-of-life tax planning. As parents’ lives draw to a close, family members usually engage in all sorts of skullduggery designed to beat the tax man. Typically, jewelry, artwork, collectibles (gold/silver coins, stamps, guns, antiques, etc.) disappear, and the homeplace is looted removing all furniture, silverware, etc. to minimize or eliminate assets that must be reported for death tax purposes. Assets that must be included (small amount of personal property and all real estate) are typically valued at “rock bottom” prices for estate tax purposes.

Those actions are not only illegal, but also represent poor tax planning in most cases. When a doctor or other family members later sell the inherited property, they end up overpaying federal and state income taxes because the property inherited did not receive a “stepped up” basis to its true fair market value at the date of death.

For optimum tax results, all property should be included, and at the highest reasonable value, if the result is that it does not push the estate into a situation where it owes federal and state death taxes. Only a few states still impose state inheritance or estate taxes, and the impact of those is generally not high enough to thwart this strategy, since federal and state income taxes on the capital gains may range from 25-30% in many cases - much higher than the typical state tax rate.

Next month, we will discuss another little-known estate planning strategy that can slash income taxes.

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