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Portability and New Adventures in Complicated Planning Issues

By Harry S. Margolis

If your estate is under $5.45 million (in 2016), it will pay no federal estate tax. (However, the threshold is $1 million for Massachusetts decedents.) With so-called “credit shelter” or “QTIP” trusts, couples have been able to double the tax-free amount, so that now a couple can protect up to $10.9 million (in 2016) from any federal estate tax. (Massachusetts residents can use the same technique to shelter up to $2 million from the Massachusetts estate tax.)

 Portability

Starting in 20__, Congress permitted surviving spouses to use the deceased spouse’s credit without setting up special trusts. This is known as “portability.”Here’s how it works:

Deceased husband has an estate worth $2.45 million which he leaves in a credit shelter trust for the benefit of his wife and children (or to his children from his first marriage). This leaves $3 million of his credit unused. With portability, his widow can add this amount to her own, allowing her to leave $8.45 million federal estate tax free. (If he gives everything to his wife he won’t use any of his credit, so the whole $5.45 million will be avaiable for portability.)

In order to take advantage of portability, the surviving spouse (or whoever is the deceased spouse’s personal representative) must file a federal estate tax return for the deceased spouse electing portability. In most cases, there’s no other reason to file a federal estate tax return since the deceased spouse’s estate is likely to be under $5.45 million. It seems like a lot of work to go through if it’s unlikely that the surviving spouse’s estate will exceed this level.

On the other hand, what if the surviving spouse’s stock options hit, she wins the lottery, or she inherits a bunch of money or valuable real estate? If the deceased spouse’s estate exceeds $1 million so that a Massachusetts estate tax return has to be filed in any case, it doesn’t take a lot of additional work or legal fees to file a federa estate tax return as well. So, that is what most probate attorneys are advising, though the ultimate decision belongs to the client.

Enter Trusts

That’s not so complicated. But now, let’s suppose the decedent had a trust in order to minimize Massachusetts estate taxes or for another reason such as (1) protecting children from a prior marriage, (2) protecting the assets from the surviving spouse’s creditors, or (3) permitting the assets in the trust to continue to grow and not be taxed even if with the surviving spouse’s own assets they exceed $10.9 million or $2 million for Massachusetts. Depending on how the trust is written and what choices the surviving spouse or the personal representative makes, the funds and property in the trust will or will not be included in the surviving spouse’s taxable estate.

  • If the trust is a “credit shelter” trust, it will not be included in the surviving spouse’s estate.
  • If it’s a “marital” trust it will be included.
  • If it’s a “QTIP” trust, the personal representative of the deceased spouse’s estate may choose whether or not it will be included in the surviving spouse’s estate by making or not making a QTIP election on the deceased spouse’s estate tax return. To further expand choices and complications, the personal representative can make different elections on the federal and Massachusetts returns, slicing and dicing the QTIP trust into separate shares to obtain the optimal tax result.

Enter Capital Gains Taxes and the Step-up in Basis

The reason the choice of trust and QTIP election matters has to do in part with the tax on capital gains. When someone dies, the basis in property adjusts to the value on the date of death. This can avoid significant taxes when the property is sold. An example should help explain how this works:

Scenario 1

Bob and Carol buy a house for $500,000. That is their tax basis in the property. (For our purposes, we will assume that they make no improvements to the property, which could increase the basis and further complicate our calculations.) When Bob dies 20 years later, the value of the property has increased to $1 million. Since Bob and Carol owned the property as tenants by the entirety the property now belongs to Carol and her basis in the property is adjusted to $750,000 — her original $250,000 basis in her half plus an adjusted $500,000 basis in Bob’s half. If she subsequently sells the property, she’ll have gain of $250,000 but won’t have to pay any taxes because that’s the amount that she’s allowed to exclude on the sale of her own home. If the property increases in value, she’ll have to pay combined federal and Massachusetts taxes of about 25% (depending on her income bracket) on the gain. So, if she nets $1.1 million, her tax will be about $25,000.

Let’s assume that Carol dies 10 years after Bob and by then the value of the house has grown to $1.5 million. This becomes the new tax basis and when the children sell the house, they won’t have to pay any capital gains taxes. However, whether or not they sell the house, they will have to pay Massachusetts estate taxes because Carol’s taxable estate including the house and her other assets will total more than $1 million. If, for example, her estate totals $2 million, the Massachusetts estate tax will be about $100,000.

Scenario 2

Let’s assume that Bob and Carol did some planning to avoid the $100,000 tax. In this scenario, Bob and Carol both created a credit shelter trusts to shelter the first $1 million of their estates. They also put the house in Bob’s name. As a result, when he died the basis in the house was adjusted to $1 million instead of $750,000. Again, if the house was subsequently sold for $1.1 million, there’d be a tax on the $100,000 of capital gain. Carol would not be able to use her $250,000 exclusion because she would not be the owner of the house, even if she’s a trustee of the trust. The big difference for tax purposes is what happens at Carol’s death. First, there’s no estate tax because she would have only $500,000 in her estate, well below the $1 million threshold. But, second, the house would not get a further adjustment in basis upon Carol’s death. So, if they sold it for $1.5 million they would realize gain of approximately $500,000 and a tax of approximately $125,000. This tax, while a bit higher than the estate tax in our example, would not have to be paid until and unless the house were sold.

Scenario 3: Having Your Cake and Eating it Too

This scenario is just like the second one, except that instead of creating credit shelter trusts, Carol and Bob have QTIP trusts. In that case, at Bob’s death Carol makes a federal but not a Massachusetts QTIP election. The result will be that the house will be in her estate for federal purposes but not for Massachusetts. Since it will be in her federal taxable estate, it will get a step-up in basis to $1.5 million, eliminating any capital gains taxes when her children sell it. And because it won’t be in her estate for Massachusetts purposes, her estate will still be just $500,000 and not subject to tax.

In order to achieve the result in Scenario 3, Carol must file a federal estate tax return electing portability upon Bob’s death, even if she feels she’s at absolutely no risk of having an estate exceeding $5.45 million.

But What if the Market Declines?

Adjustments in tax basis at death can go down as well as up, for better and for worse. Let’s see how that could play out:

Scenario 4

Let’s assume that real estate market declines 25 percent after Bob’s death and when Carol dies the house has a value of just $750,000.

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