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News

(October 24, 2014)

The New Rules of Estate Planning

For Many Families, the Focus Is Now on Minimizing Capital-Gains Taxes and State Levies

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By Laura Saunders

Oct. 24, 2014 12:15 p.m. ET

The estate tax is no longer the biggest concern for most affluent people who want to avoid taxes on wealth they leave their heirs.

For much of the past decade, it was. In 2004, for example, the estates of people who died owning assets worth more than $1.5 million—or who made gifts above that limit during life—were subject to federal tax at top rates approaching 50%, and married couples had to set up trusts to benefit from their full $3 million estate exemption.

In addition, there was extreme uncertainty as the tax bounced around from year to year and even disappeared entirely in 2010—making effective planning excruciatingly difficult.

Finally, last year, Congress set the top estate-and-gift-tax rate at 40% and raised the exemption to $5 million per person, adjusted for inflation. It now stands at $5.34 million and is expected to rise to $5.43 million next year. Lawmakers also changed the rules so that couples don’t need trusts to get their full break from Uncle Sam.

These changes have freed hundreds of thousands of affluent Americans from worrying about federal estate tax, and they may never have to. Many experts think that Congress, scarred by years of turmoil over the estate levy, is averse to making further big changes. Michael Graetz, a former Treasury Department official who teaches at Columbia University’s law school, says lawmakers would sooner repeal the tax than lower the exemption.

The new rules present tax-saving opportunities that many people planning estates still are unaware of—and that could contradict advice they received in the past. “The conventional wisdom has been turned on its head because of changes in both the income tax and the estate tax,” says Suzanne Shier, chief tax strategist at Northern Trust in Chicago.

In the past, for example, avoiding the estate tax often meant forgoing efforts to minimize long-term capital-gains taxes, which had a much-lower top rate of 15%, Ms. Shier says.

But now many people who won’t owe estate tax can reap substantial tax savings on capital gains by choosing carefully which assets to hold until death. This strategy is especially useful now that the top federal rate on long-term gains is nearly 24%, two-thirds higher than in 2012.

The high exemption also is prompting changes in gift strategies and trusts, says John O. McManus, an estate lawyer in New York.

In other cases, say experts, state estate and inheritance taxes are looming larger because the federal estate tax now affects so few people.

The upshot: People covered by the federal estate-tax exemption should review the plans they have in place to look for more tax savings. Here are important factors to consider:

Capture Capital-Gains Savings

The federal code has long had a provision, known as the “step-up,” that cancels the long-term capital-gains tax on assets that a taxpayer holds until death. The step-up automatically raises the owner’s cost basis for such assets—the starting point for measuring a taxable gain—to its full market value as of the date of death.

For example, say an investor bought a piece of land or stock shares many years ago for $20,000, and the value has grown to $200,000. If the investor sells the asset before his death, he will owe capital-gains tax on the $180,000 profit, at a rate as high as 23.8%—the 20% top rate on long-term gains, plus a surtax of 3.8% levied on higher-income taxpayers.

If the investor holds the same asset until death, however, the capital-gains tax vanishes. The asset will be included in the owner’s estate at full market value, where the exemption of more than $5 million per person could shelter it from federal estate tax as well.

The new focus on the step-up prompted Ren Grevatt, now 94 years old, to do an about-face in his estate plan. For years, says his son Jonathan, who helps his father with his affairs, planners suggested that the father give his children the family’s beloved seven-bedroom Vermont farmhouse to avoid estate taxes that could have forced a sale.

Now Mr. Grevatt plans to keep the house until he dies. He and his 87-year-old wife, who live in New Jersey, bought it for less than $100,000 in the 1960s, shortly before he became a publicist for such rock groups as the Beatles, the Rolling Stones, Led Zeppelin and the Who. The house, which is in prime ski country with views of two lakes, has appreciated greatly.

As the parents’ estates will total less than $10 million together, no federal estate tax will be due. By holding on to the house, however, the parents will enable their children to inherit the property at its current market value—and skip capital-gains tax of up to 24% on decades of appreciation.

“I’m glad my father didn’t get around to giving us the house,” says the younger Mr. Grevatt.

Experts recommend scrutinizing which assets to hold until death to maximize the step-up. This move is especially important in high-tax states such as California, where the top combined federal and state capital-gains rate exceeds 35%.

Tap the Right Assets

To meet cash needs, some advisers say, it may even make sense to take out a loan rather than selling appreciated investments in taxable accounts, especially with interest rates low.

Another strategy: making withdrawals from traditional individual retirement accounts or other retirement plans. Because such assets are in tax-deferred accounts, they don’t get a step-up in basis.

“Income taxes on a traditional IRA are largely unavoidable unless the assets are donated to charity, while the capital-gains tax can be optional,” says Eric Lewis, chief investment officer at Bedrock Capital Management in Los Altos, Calif. Still, he says, investors should be careful not to take on excessive risk—or abandon their overall strategy—to minimize taxes.

What about assets held jointly by a married couple? In nine states with community-property laws, including California and Texas, the survivor typically gets a full step-up on joint assets after the first spouse dies.

In most other states, the step-up resets half the value of a joint asset after the first death. So if a couple jointly owns the asset described above, which had a cost of $20,000 and current value of $200,000, then at the wife’s death the husband’s cost basis in the asset would rise to $110,000—$10,000 for the husband’s portion and $100,000 for the current value of his wife’s share.

At that point, his taxable gain would be $90,000, although no tax is due unless he sells it.

Many planners are advising couples to review their assets with the step-up in mind. For this reason, says Joe McDonald, a lawyer with McDonald & Kanyuk in Concord, N.H., one of his clients gave her husband half of a highly appreciated portfolio of stocks that she inherited years before from her family.

“She always felt she shouldn’t share ownership because the gift came from her family, but she decided to after learning about the taxes,” he says. (Under federal law, the recipient often has to survive the transfer for a year, or the recipient's estate doesn’t get the step-up.)

Rethink Your Trusts

The growing prominence of the step-up also affects tax-saving trusts. Until the advent of a provision known as “portability” in 2011, spouses often needed trusts to provide their estates with the full value of two federal estate-tax exemptions.

Now, however, a surviving spouse can claim the unused portion of a partner’s exemption. So if a man dies and leaves $1 million to his children, his widow can claim his unused $4.34 million and, adding it to her own full exemption, have more than $9 million for use at her death. (The survivor must file Form 706 with the Internal Revenue Service within nine months of the death to claim the unused exemption.)

Experts say many couples still have tax-saving trusts set up years ago that could actually raise taxes for heirs. For example, if the first partner to die leaves a $2 million estate to a trust under the terms of a 2007 will designed to protect his estate-tax exemption, then there will be no step-up on the subsequent growth of these assets. But if the person leaves the same assets directly to the spouse, future growth could escape capital-gains tax at the second death.

Jon Robertson, a financial planner at Abacus Planning Group in Columbia, S.C., works with a couple with a net worth of less than $5 million who have decided to get rid of their trusts. “This strategy will preserve the step-up, minimize administrative fees and keep things simpler,” he says.

People with more sophisticated tax-saving strategies, such as a grantor-retained annuity trust, or GRAT, also should re-examine them with the step-up in mind. GRATs are used to transfer the appreciation in an asset that is expected to surge in value—but the asset often has a low cost-basis. Now, says Ms. Shier of Northern Trust, it could make sense to replace a low-cost asset in the GRAT with a higher-cost one.

Who still needs tax-saving trusts? Many couples in states with death taxes, experts say. (See below for more information.) In addition, trusts can be crucial for married couples in which one spouse is a U.S. citizen and the other isn’t, says Phil Hodgen, an international tax expert in Pasadena, Calif.

Some advisers are also turning to a long-dormant arrangement often called an “estate trust.” It uses complex moves to provide a double step-up on a highly appreciated asset to a married couple after the first spouse dies. In effect, this trust aims to give couples who don’t live in community-property states the same advantage as those who do.

“This strategy provides flexibility by enabling the surviving spouse to sell the asset sooner,” says Mr. McManus, the New York lawyer, who advised the Grevatts.

Reconsider Gifting

Advisers are urging clients to take a hard look at the gifts they make to other people as part of their estate planning. Deena Katz, a prominent financial planner married to another one, Harold Evensky, is doing it, too.

“There’s almost no reason to make gifts anymore unless there’s a mega-estate, or someone needs help,” says Ms. Katz, who now lives in Lubbock, Texas. Another exception: when state death duties are an important issue.

When a person gives a noncash asset to someone else, the original owner’s cost basis carries over to the recipient. So if an aunt gives her nephew stock shares worth $10,000 that she acquired for $500 many years ago, then the nephew’s cost basis will be $500 when he sells the stock.

By contrast, if the aunt leaves the shares to the nephew at her death and they are worth $10,000, that becomes his cost basis—and there isn’t tax on the gain between $500 and $10,000.

Given that the top federal rate on long-term capital gains is nearly 24%, compared with 15% a few years ago, the best course for people who won’t owe estate tax is often to forgo the gift and wait for the step-up, experts say. That is why Mr. Grevatt and his siblings were relieved their father never gave his children the Vermont property outright.

Beware of State Taxes

Nineteen states and the District of Columbia—home to about one-third of the U.S. population—levy an estate tax on the assets of people who die or an inheritance tax on those receiving the assets, or both.

While a few states have exemptions as large as Uncle Sam’s, the break is far lower in others, including New Jersey, Massachusetts and Oregon. Rates can be as high as 20%, says Jim Walschlager, state tax specialist at Wolters Kluwer, CCH.

There also are quirks in some state levies. New York, for example, will soon have an exemption of more than $3 million per person—but people whose assets are greater than 105% of the break get no exemption at all. This provision is often called “the cliff.”

In addition, few states follow the federal portability rules, so couples may still need trusts to get the benefit of two exemptions. It also could make sense for taxpayers to make gifts while they are alive, as only one state—Connecticut—currently has gift tax, Mr. Walschlager says.

For taxpayers living in states with death taxes, the good news is that there is a trend toward larger exemptions. New York, Minnesota, Tennessee, Illinois, Rhode Island, Maryland and Vermont all have raised theirs in recent years, and several have further increases slotted.

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A version of this article appeared October 28, 2014, in the U.S. edition of The Wall Street Journal, with the headline: The New Rules of Estate Planning