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How to Write a Will to Reduce Taxes (and How Not to)

I was recently asked whether a will should direct that all property, including real estate, stocks and bonds be sold and the proceeds be distributed to the named beneficiaries, including several charities. That could definitely work fine if everything were sold at the moment of death, but nothing works instantaneously and the result of requiring all property to be sold could mean unnecessary taxes on gains for beneficiaries.

Capital Gains

All your property receives a step-up in basis upon the death of the owner. This means that upon the sale of property in an estate, any capital gain will only be the result of an increase in value from the date of death until the property has been sold. If the market is relatively stable, there should be little or no gain when the property is sold. However, it can take several months for personal representatives of estates (executors) to get appointed and gain access to funds. During that time both the stock market can fluctuate dramatically. Some beneficiaries may prefer to receive shares of stock outright and choose to sell them at a time that is more opportune for them rather than having to pay their share of the tax on any capital gain at the outset.

In additions, since charities don’t pay taxes, it could make sense to allocate appreciated property to charities and non-appreciated property to other beneficiaries. That way, the charities can then sell such assets without incurring any taxes and the tax burden will also be reduced for other beneficiaries. The result of all these possible considerations is that at least for stocks and other investments, it makes most sense to leave the determination of whether to liquidate them to the personal representative just in case there could be some savings by being selective.

Real Estate as an Exception

However, the story is different with regard to real estate. First, it’s much harder to divvy up real estate and leaving it up to the beneficiaries to decide whether to sell it can create conflicts. It may well be simpler for the heirs if they have no choice in the matter with the property sold and the proceeds distributed as soon as possible.

The second reason to direct the sale of real estate is that it could mean a tax savings if the entire estate is taxable. When the personal representative must sell real estate, the estate can deduct the broker’s commission and any other expenses related to the sale on the estate tax return. For most estates this is irrelevant because the federal estate tax threshold is currently just over $12 million, but the estate tax threshold in Massachusetts is $1 million, tied with Oregon for the lowest level. (A recent effort by the legislature to raise it to $2 million faltered when it discovered that due to a little-known law and a budget surplus, the state may have to return billions to taxpayers.)

IRAs and Retirement Plans

IRAs and retirement plans add a further complication. To the extent they’re payable to charities, the charities can liquidate the funds without paying taxes. If they’re payable to individuals, most beneficiaries can stretch out the withdrawals over 10 years. Certain qualified beneficiaries can stretch them out over their lifetimes. However, if the same IRA or retirement plan names both charities and individuals as beneficiaries, all the individual beneficiaries must make their withdrawals within five years. This is also true if they’re payable to an estate to be divided under a will rather than naming specific beneficiaries. This means that it almost always makes sense for IRAs and retirement plans to name beneficiaries so they don’t come under a will. If they are to be divided between individual and charitable beneficiaries, they should be beneficiaries of different accounts getting as close to the desired split as possible. The individual could make up the difference in their will or decide that close is good enough.

Actual Language of the Will (or Trust)

With that background, I recommend that wills include a paragraph related to real estate that says something like: “I direct that any real estate in which I may have an interest at my death be sold and the proceeds added to the remainder of my estate.”

Then the will should have a paragraph dealing with the remainder of the estate (other than any specific bequests (gifts) and tangible personal property — things you can touch, such as furniture, jewelry and artwork). This can be written in a number of different ways. I often like to differentiate between allocation, the division into shares, and the actual distribution — saying what happens to the allocated funds. So this could read something like this: “My personal representative shall divide the remainder of my estate into two equal shares and pay one share equally to the following charity 1, charity 2, and charity 3, and pay the other share equally to the following individuals: . . .” Of course, this can be divided in any way the individual chooses, perhaps a quarter to charities and the rest to other beneficiaries. In fact, most people don’t include charities in the distribution of the bulk of the estate, instead giving them smaller specific bequests.

With respect to charities, it’s wise to include another clause in case the charity doesn’t exist at the time of distribution, something to the effect: “If any of these charities does not exist at the time of my death, my personal representative shall pay that charity’s share equally to the other charities listed above.” Or: “If any of these charities does not exist at the time of my death, my personal representative shall pay that charity’s share to a different charity that serves a similar purpose, the decision of my personal representative to be solely within her discretion and not subject to review.”

With respect to the individual beneficiaries, the individual also has a choice of what to do in case any of them doesn’t survive the person writing the will. One choice is to distribute their share to the other surviving beneficiaries. The easiest way to do this is to change the language above by qualifying the recipients to those who survive, as follows: “My personal representative shall pay the other share equally to those of the following individuals who survive me: . . .” In the alternative, the individual can provide that the share of any individual who does not survive you passes to their children equally or can provide specific instructions for each individual, for instance for some that it passes to their spouse.

Finally, the allocation could take into account the potentially unequal distribution of IRAs and retirement plans: “My personal representative shall divide the remainder of my estate into two shares designated as share A and share B. Share A shall be the amount necessary to give half of my entire estate to charities, taking into account any other property that may have passed to charities and others by reason of my death. Share B shall be the remainder of my estate.”

Can’t We Keep it Simple?

Of course, all of these considerations involve somewhat larger estates with somewhat more complicated distribution plans. If your estate is not taxable (under $1 million in Massachusetts) and you don’t want to give a share to charities, it can make sense simply to say, sell all my stuff and distribute it equally to your beneficiaries. The considerations discussed above concerning stocks and capital gains matter more the greater the value of such investments. Personal representatives and their lawyers and accountants can sometimes spend an inordinate amount of time and energy (and cost of it they’re billing for that time) trying to save just a small amount of taxes.

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