Major tax reform discussions are ongoing in Washington and Sacramento while everyone at home is busy navigating the pandemic. Many commentators are predicting that budgetary pressures resulting from the COVID-19 stimulus measures will necessitate a near-term reversal of some of the 2017 federal tax cuts and provide further rationale for the passage of significant California property tax propositions. We encourage you to revisit your estate plan and consider gifting strategies in light of the potential legislative changes and unprecedented economic environment as highlighted below.
Estate, Gift, and GST Tax Increases Under Biden’s Proposal
In 2020, the lifetime exemption allows individuals to transfer up to $11.58 million free of estate and gift tax and generation-skipping transfer (“GST”) tax either by gift during life or upon death. Transfers in excess of those exemption amounts, other than to charity or to or for the benefit of a spouse, are taxed at a 40% rate. Biden and Sanders published 110 pages of policy reforms that would restore the estate tax regime to the “historical norm.” Many commentators are speculating this proposal means reducing the estate and gift tax and GST tax exemptions from $11.58 million per person to $3.5 million per person. However, “historical norm” could also mean even lower exemption amounts and a higher tax rate. If not sooner amended, the estate and gift tax and GST tax exemptions are slated to revert to pre-2017 levels effective January 1, 2026, absent Congressional action.
The IRS issued guidance confirming that transfers taking advantage of the current exemption amounts will not be “clawed back” by a change to the law, making 2020 the time to utilize the balance of your exemptions by making gifts before any legislation becomes effective.
Property Tax Increases Under California Propositions 15 and 19
Propositions 15 and 19 will be on California’s November 2020 ballot and, if passed, could significantly change the property tax landscape.
- Proposition 15: Split Roll Tax for Commercial/Industrial Properties. The “split roll” would assess taxes for certain commercial and industrial properties based on their fair market value. Accordingly, Prop 15 removes limitations established under Proposition 13 (1978) that place a 2% cap on increases to the assessed value of these types of properties. Commercial or industrial properties whose fair market value does not exceed $3 million are exempted from Prop 15 reassessment. There is a significant exception to this $3 million threshold: the value of a subject property must be aggregated with the values of any other commercial or industrial properties in California for which a direct or indirect beneficial owner of the subject property shares a direct or indirect ownership interest. Note that the split roll system established under the Prop 15 proposal does not change the overall property tax rate, nor does it apply to residential property or agricultural property.
- Proposition 19: Change Assessed Value Calculations for Residential Property. Proposition 19 would expand exemptions allowing certain homeowners such as those over age 55 to transfer their assessed values to replacement residences in different counties within California, but would significantly narrow or eliminate existing exemptions from reassessment for other intra-family transactions.If you have any California real property with a low assessed value that you hope to pass to future generations, there are several strategies you might consider to take advantage of the current expansive exclusions from reassessment. See a more detailed explanation of Prop 19 here.
Low Interest Rates Favor GRATs, CLATs, and Sales to IDGTs
The current low interest rate environment makes certain wealth transfer vehicles especially attractive. Three of these techniques are briefly described below.
- GRAT. A grantor retained annuity trust (“GRAT”) is a short-term irrevocable trust to which you transfer property that you expect to appreciate or generate income at a rate greater than that assumed by the IRS. The GRAT pays an annuity back to you during the trust term roughly equal to 100% of the value of the assets at the time you transferred them into the GRAT plus interest at a rate which the IRS publishes on a monthly basis. To the extent that the contributed assets generate income or appreciate at a higher rate than that IRS assumed rate, the excess appreciation passes to your beneficiaries free of tax. See a more detailed explanation of GRATs here.
- CLAT. A charitable lead annuity trust (“CLAT”) is similar to a GRAT, except that the annuity is paid to a charitable beneficiary. The annuity distributable to the charitable beneficiary can be set at a value of the assets contributed to the trust. The non-charitable beneficiaries receive all appreciation above the contributed amount adjusted for the hurdle rate. A CLAT can be structured either to provide you a charitable income tax deduction in the year of creation or provide the CLAT deductions for the annuities paid to the charitable beneficiary. Please contact us to discuss the many variations on and ways to structure CLATs if you are interested in gifting a portion of your estate to charity.
- Sales to IDGT. A sale of assets to an irrevocable grantor trust (“IDGT”) is a tax-efficient way to further leverage the use of lifetime estate, gift, and GST tax exemptions. Assets are sold to the IDGT in exchange for a note which bears interest at a rate tied to the IRS assumed “applicable federal rate,” which presently is very low. The IDGT pays you the low interest and principal for the duration of the note. You pay the income taxes on assets owned by the IDGT (for as long as you wish) which is a further tax-free wealth transfer. There are many ways to tailor sales to IDGTs that we are happy to discuss with you in more detail.
Low Income Tax Rates Favor ROTH Conversions
It is unknown what future income tax rates will be, but income tax rates for high-earners may be increased through Biden’s proposal to reverse the 2017 tax cuts or other California and federal proposals to increase tax revenue after the COVID-19 stimulus. Federal and state taxes are owed on the conversion; however, future distributions from the Roth account are then income tax-free. Contact your financial advisor to discuss whether a Roth conversion or partial conversion is advantageous.
Tax Haven States Benefit Trust Planning for Legacy Assets
California’s high state income tax rates are encouraging residents to move out of state, but another option may be to transfer legacy assets to a trust in a favorable tax state. Legacy assets that are expected to be held for future generations and not used for current expenses or distributions might be held in a trust outside of California and accumulate and grow free of state income taxes. We are happy to discuss the optimal structure for legacy assets and advantages of different states with you in more detail.
 Earlier in his campaign, Biden proposed eliminating the step-up in basis at death so that beneficiaries would have income tax due on the sale of estate assets.