Estate planning is about making sure all of your financial assets transfer to your loved ones when you die. That part is easy. The bigger challenge is making sure they pass to your loved ones without different fees, costs and taxes eating up those assets.
The obstacles that you must negotiate around are what I call the Four Horsemen of the Estate Planning Apocalypse. They are, in no particular order, (1) Probate Court, (2) Estate and Gift Taxes, (3) Property Tax Reassessment, and (4) Capital Gains Tax. They are not all equal in threat, and which one of these Four Horsemen poses the biggest threat is constantly changing, and also depends on your own circumstances.
The first of the Four Horsemen, Probate Court, is the Horseman you face if you die with over $166,250 in probate assets. It’s ugly. The estate’s assets may be tied up while the estate goes through probate proceedings that could have been avoided. The estate will pay a lot in fees. An estate with a gross value of $1,500,000 will pay a statutory probate fee to an attorney totaling $28,000 If the estate doesn’t have a family member who is willing to act as executor for no fee, the estate will have to pay another $28,000 Probate court is a particularly mean Horseman, but it’s not difficult to defeat him. You put your assets into a living trust. Easy. Done. You’ve slain the first Horseman.
The second of the Four Horseman, Estate and Gift Taxes, used to be the most powerful of them all, but not so much anymore. (At least not for the vast majority of us) Go back to 2003, which is really not that long ago. Any estates that were over $1,000,000 were subject to federal Estate and Gift taxes. Sure, $1,000,000.00 was worth a lot more in 2003 than it is now, but that was a pretty low limit for a lifetime’s worth of assets, especially in California where half of that could be eaten up by one’s (modest) home. Estate Planning in 2003 was largely an exercise in figuring out how to shelter assets from Estate and Gift tax. But not anymore. The lifetime Estate and Gift Tax exclusion today is $13,610,000 That’s a lot. And that doesn’t even take into account the fact that a surviving spouse may, with a relatively simple IRS filing, “appropriate” their deceased spouse’s Estate and Gift Tax lifetime exclusion and add that amount to their own. So a surviving spouse can pass on $27,220,000 in assets before ever having to pay a dime in Estate and Gift Tax. Even most wealthy people these days are in no danger of paying Estate and Gift Tax. To illustrate, you could own a $10,000,000 beach house in La Jolla, a $5,000,000 apartment in Manhattan, and a cool $10,000,000 in cash/securities, and still not have to pay one penny in Estate and Gift Tax. This Horseman is indeed a shadow of its former self. But, don’t count this Horseman out entirely. The $13,610,000 exclusion is set to sunset at the end of 2025. If Congress doesn’t act before then, the exclusion amount will go back down to $5,490,000. Nobody knows the future, but a lot of us are expecting that Congress will find a way to deal with this issue before 2026.
The third of the Four Horsemen, Property Tax Reassessment, is almost the mirror image of Estate and Gift Tax Horseman, in that it used to not be a powerful foe at all, but now it is, with some exceptions. It used to be, prior to the passage of Prop. 19, that you could transfer your property to your children or grandchildren, and it would not trigger a property tax reassessment. So if you purchased a home a long time ago and were enjoying very low property tax payments (thanks to Prop. 13), so would your kids and grandkids. As anyone who owns property knows, this is huge. Property Tax is roughly 1% of the assessed value of the home, but because of Prop. 13, it can only increase 2% a year. Because of skyrocketing home values in California, homes purchased a long time ago pay a fraction in property tax of what the property would be assessed for now. It was a bonanza for people who were living in homes that they, or their parents or grandparents, had purchased decades ago. But then The Dude and his family (aka Jeffrey Lebowski, aka Jeff Bridges, his brother Beau Bridges, their sister, and their parents, Mr. and Mrs. Lloyd Bridges, ruined it all (sort of).
In 2018, Los Angeles Times journalists Liam Dillion and Ben Poston wrote what turned out to be a highly influential article pointing out the tax inequities enjoyed by wealthy real estate owners who bought and held on to their expensive properties. At the centerpiece of the article was the Malibu home purchased in the 1950s by the late actor Lloyd Bridges and his wife. When Mrs. Lloyd Bridges passed away, the Bridges children inherited the property, along with the ridiculously low property tax assessment that their parents enjoyed. In 2018, the property was estimated to be worth 6.8 million, and someone purchasing that property in 2018 would have paid roughly $76,000 annually in property tax. The Dude and his siblings, however, were having to pay only $5700 annually in property tax. (Some of you are probably paying more than that on your non-Malibu, non-beachfront home). And to further compound the inequality, none of the Bridges children were actually living in the house. Instead, they were renting out the property for a shade under $16,000 per month. The Dude abides, indeed.
So, in 2020, voters passed Prop. 19, which altered the property tax structure. Homeowners got a benefit. They were allowed, after the age of 55, to keep their low property tax assessment when they sold their house and bought a new house somewhere else in the state (Previously, they had to remain in the same county to preserve their low property tax assessment). In exchange for that, they gave up the ability to transfer their low property tax assessment to their children and grandchildren upon their passing, unless the child or grandchild were to reside in the property. If the child or grandchild didn’t file an affidavit every year swearing under penalty of perjury that the inherited property was their primary residence, the property tax would be reassessed to current levels.
There’s no proven way to get around Prop. 19. If you inherit property, and you don’t live in it, the property tax is going to be reassessed. But you can sell the property and not be burdened with the additional annual property taxes.
Finally, the last of the Four Horsemen is Capital Gains Tax. This Horseman doesn’t just affect people in the Estate Planning area. Everyone who owns property needs to fear this Horseman. Because the extremely fast-rising value of real estate in California has overwhelmed the protections that have been in place for decades for homeowners selling their primary residence. And it can have estate planning consequences as well, for some (but not all) couples.
Capital Gains tax works like this: When you sell a home, it’s like any other asset you own. If it has appreciated in value, you have to pay Capital Gains tax. And, the story of real estate in California has been, for the most part, ever-appreciating real estate values. A home purchased in the late 1990s in San Diego County is likely today worth at least 5x what it cost 25+ years ago. A home purchased for $300,000 in 1997 is worth over 1.5 million today. Someone selling that home today would net a profit of 1.2 million. (The original $300,000 for Capital Gains Tax purposes is referred to as your “basis” in the property.)
1.2 million in profit sounds great! That is, until you realize how much of that is going to get eaten up by Capital Gains tax. If you’re selling investment property (not your residence), you can defer the Capital Gains tax by using the funds from the sale of the investment property to purchase another property. That’s fine if you’re selling investment property. But what if you’re just selling your residence because you want or need to move? Well, there used to be a pretty good solution to that problem. On the sale of a primary residence, a married couple could, one time, shelter $500,000 from Capital Gains tax. That was fine before property values went insane. A $500,000 shelter from Capital Gains tax was more than enough to make it so only the filthiest of filthy rich homeowners would ever exceed that amount, and even then it would take decades for their home to appreciate to that level. But today, that $500,000 is a pittance. As recently as 2018, the median price of a detached home in Orange County was $785,000. By 2023, it was $1,300,000. That means that a person who bought a median-priced house in Orange County as recently as 2018 would have already exceeded their $500,000 Capital Gains Tax shelter, and have to pay some Capital Gains tax on the sale of their residence. Now, imagine someone who bought their median-priced home earlier, like in 1995. That median-priced home would have cost $178,000 in 1995. Even with $500,000 shelter, a married couple selling their home in 2023 would pay Capital Gains tax on $622,000! Assuming they were paying the lowest Capital Gains tax rate (15%), that would result in Capital Gains taxes of $93,000.
If you’re scared/freaked out right now, I apologize. But it is a major problem for people who need to sell their residence and move, because they’re likely going to need that appreciated equity in their ridiculously-priced former house to be able to afford to move into a ridiculously-priced new house.
However, for couples who are not needing to immediately sell their primary residence, it’s much less of an issue, if it’s even an issue at all. The IRS grants very favorable tax treatment to married couples in California due to California being a Community Property state. IRS rules allow for a “step-up” in basis for when one spouse dies, and the surviving spouse becomes the sole owner of the property. The surviving spouse’s basis in the property is “stepped up” to the value of the property at the time of the first spouse’s death. The result is that a surviving spouse who sells the property immediately after their spouse dies pays nothing in Capital Gains tax. The same is true for inherited property. When someone inherits property, they receive a “stepped up” basis to the value of the property at the time of the owner’s death. If they sell the property immediately, there is no Capital Gains tax.
In the area of Estate Planning, the “stepped-up” basis makes Capital Gains tax avoidance easy for some couples. But not for all. Where this benefit breaks down is when spouses hold separate property, because the “step up” in basis among married couples only applies to community property, not separate property. (Separate property, generally, is property that a spouse inherits, or owned prior to the marriage). And that presents some Estate Planning pitfalls for married couples where one or more spouses owns separate property, as I will illustrate.
Suppose a married man owns a home as separate property, and he wants to make sure that property eventually goes to his daughter. He wants his his wife (with whom he lives in the property) to have the benefit of the property while she’s alive, but doesn’t want to outright give the property to her, because he’s worried that she might end up remarrying and give the property (which he intends for his daughter to have) to her new husband or her new husband’s children. He trusts his daughter to take care of his wife, so he decides to transfer the property to himself and his daughter as joint tenants. When he dies, the property belongs entirely to the daughter. The daughter allows the wife to live in the property for the remainder of her lifetimes. All’s well, right? Well, not exactly. The daughter may have significant Capital Gains tax liability when she goes to sell the property. Only half of the property (the half she inherited upon her father’s death) is going to receive a “step up” in basis. The other half is going to have as its basis one-half of the fair market value of the property on the date that that half of the property was transferred to her. The increase in appreciation, even in just one half of the property could result in a significant Capital Gains tax hit. There are ways around this conundrum, but they involve a lot of planning, and may involve giving up some control of the property.
This is why you should always consult with an Estate Planning attorney instead of trying to do it yourself using software, or going to an inexpensive “Will and Trust Mill”, and why it’s also a good idea to go over your Estate Plan with an attorney every few years to make sure that changing circumstances haven’t caused issues with your existing estate plan. You never know if one or more of the Four Horsemen of the Estate Planning Apocalypse is lurking around the corner. If you need an Estate Plan, or it’s been a while since your existing plan was drafted, please give me a call. I’d love to help you slay the Four Horsemen.