February 3, 2016
With the local economy doing as well as it is, I have been having a fair number of clients contact me to discuss transferring their appreciated improved property or businesses to their children to avoid probate and to make it easier on their children after they die. Their assets have been in the family for a long time, they have substantial value and they have little or no adjusted basis because of when they were acquired and the depreciation that has taken place over the years. Most of these clients have net worth's in the $5-10 million range, so Medicaid eligibly is not on the table, and they have Wills utilizing the credit shelter trust mechanism to maximize the use of the federal unified credit for federal estate taxes purposes. So, the question becomes, is this a good idea?
I normally start off by reminding my clients that Texas has one of the easiest and cost effective probate systems in the country. If proper planning is done in advance of death, the Texas probate system is not to be feared. This may not be the case in some other states. I also remind my clients that under the federal estate tax laws, property included in the decedent's estate, and the surviving spouse's share of the community property,receives a step up basis to the property's fair market value on the date of the decedent's death. This step up in adjusted basis can result in huge income tax savings if assets with high fair market values and low adjusted basis are sold.
Using one of my clients' situations as an example, my clients had an office warehouse building valued at $2 million that they wanted their children to receive. My clients had little to no adjusted basis in the building due to its age and the depreciation taken on it over the years. My clients left everything to their two children under their Wills.
If my clients transferred their building to their two children prior to their deaths, each child would receive an undivided one-half interest in the building with a fair market value of $1 million and an adjusted basis of near zero. With an adjusted basis of near zero in the building, neither child would be able to take any deduction for depreciation to shelter income generated by the building's rental operations. If they sold the building at some point in the near future, the children would have no adjusted basis in the building and would each report and pay federal income taxes (at capital gains rates) on the sales price they received. In this example, depending upon each child's federal income tax brackets, each child would probably be paying between 15-20% of the sales price in federal income taxes associated with the sale, and an additional 3.8% of the sales price if the net investment income tax applied. The clients would also need to prepare and file a federal gift tax return reporting the gift of the building to their children.
If the clients had waited to transfer the building to their children when they had both died (by Will), the building would have received a step up in its adjusted basis to its fair market value on date of death of the surviving parent. The children could then begin claiming a depreciation deduction based upon the new adjusted basis each of them had in the inherited building. This depreciation deduction would help shelter some of the income generated by the rental activities of the building. If the children ever sold the building, the children would have a substantial adjusted basis in the building to shelter some of the capital gains tax and net investment income tax. Depending upon how quickly the building was sold after death, the savings could be in the hundreds of thousands of dollars. All, in this case, to avoid probate which would probably cost less than $5,000.
We all want to leave our children in the best financial position once we have passed and this example is something to think about as you'reassessing your estate and planning for the future. If you have any questions about transferring your assets or the probate system in Texas, please don't hesitate to contact us.