Navigating the Gift and Estate Tax Maze

This week, Gail explains recent changes to the laws governing gift and estate taxes, and advises you to be prepared to make adjustments as the situation changes.


Dear Gail;

My parents have been talking with a number of advisors — attorneys, a CPA, financial planner, etc. — in order to make sure their estate is set up to avoid estate taxes at their deaths, if at all possible. They're not filthy rich, but because they live in California and have owned their home for over 40 years, they've seen a lot of appreciation there. They also own a couple of rental properties bought years ago.

They both worked all their lives, so they've got retirement accounts and they've accumulated a surprising amount of money just by making regular investments over the years. When you add everything up, I figure their estate is worth roughly a little over $3 million, which really surprised me.

Right now, they're both healthy and in their mid-to-late 70's. They've got one attorney telling them they need to set up trusts and someone else telling them they should start giving property away to reduce their taxable estate. But won't they owe gift tax on that?And isn't the estate tax going away? So do we really need to be concerned about that?

Any help you can give would be greatly appreciated,



Dear Jamie,

As I'm sure you heard, based on the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), the federal estate tax is slated to be phased out in 2010. However, the Act itself is scheduled to "sunset," or expire, at the end of that year. Which means, as things stand today, the estate tax will be back in 2011. Recently, Senator Charles Grassley, Chairman of the Senate Finance Committee, has introduced a bill that would make all of the provisions in the 2001 Act permanent. But your guess is as good as mine as to whether this will pass or not — especially given the nature of election-year politics.

So we're faced with the frustrating reality of not really knowing WHAT the estate tax will look like in any particular year beyond the current one. Frankly, given Congress' inclination to re-arrange the tax code whenever it wants, this has always been the case. The best you can do is work within the law as it stands today and be prepared to make adjustments as the situation changes.

The first thing to recognize is that estate and gift taxes are simply the price you have to pay to transfer property to someone other than your spouse. The estate tax applies to assets transferred at death, while the gift tax applies to assets transferred while you're alive.

(You can transfer as much as you want to your spouse without triggering estate or gift tax. The problem is that if your spouse ends up owning all of the assets — you're just postponing the tax consequences, you're not really avoiding them. They'll come due either when the surviving spouse gives the property away or when he/she dies and the property is subject to estate tax.)

Because it is not entirely heartless, the federal government allows you to transfer a certain amount of property to non-spouse individuals — your children, for example — without imposing a tax on this amount. But it accomplishes this in a rather convoluted manner.

Instead of simply saying, "While you're alive, you can give away X amount of dollars" or "Upon your death you can leave Y amount of dollars," you have to calculate the tax you owe on the total amount you've given away over your lifetime and when you die. Then, from this you subtract the tax "credit," which corresponds to the amount of property you're allowed to transfer tax-free. This is known as the "exclusion" amount because it is excluded from tax.

Until this year, it didn't matter whether you gave someone property while you were alive or bequeathed it to them at your death. The amount you could get rid of — dead or alive — without owing any tax was the same. In 2001 the "exclusion" amount was $675,000. Last year, it was $million. Moreover, the tax you paid if you transferred more than the "exclusion" amount was also identical.

Starting this year, that is no longer the case.

Let's begin with the gift tax.

As you may know, this year, you can give to as many individuals as you want up to $11,000 each in property without owing gift tax. If grandma did this with six grandchildren, she could give away as much as $66,000 and not owe a dime in gift tax. However, the minute you make a gift worth more than $11,000, you have to file a gift tax return (IRS Form 709) to report the "excess" gift amount.

But this doesn't mean you have to pay any gift tax — yet. Under the 2001 Tax Act, your excess annual gifts have to total $1 million before any gift tax is due. That's because under the law you are entitled to a tax credit which offsets up to $345,800 in gift tax — the amount of tax you would otherwise have to pay to transfer $1 million worth of property.

However, beginning this year, you get a bigger tax credit when you transfer property at death — $555,800 to be exact. This is the amount of estate tax you'd owe if you left $1.5 million to folks other than your spouse when you died. In other words, starting this year, you are able to bequeath (transfer at death) $500,000 more in property than you can give away while alive — tax-free.

Now here's the critical thing to understand: the non-taxable amount you can give away while alive and the non-taxable amount of assets you can pass at death are interrelated. While the maximum tax credit you're entitled to is $555,800, only $345,800 of that can be used to offset any gift tax you might owe. The remainder can only be applied against estate tax. If you make $1 million worth of taxable gifts and use up the full $345,800 of available "gift tax" credit, this leaves only $210,000 to offset any estate tax which might be due at your death.

For instance, suppose your father decided to give you and your siblings each $100,000 this year, which would reduce his portion of your parents' taxable estate by a total of $300,000. Looking at each gift separately, your father exceeded his annual tax-free gifting amount ($11,000) by $89,000 per child. The gift tax return he would file with his 2004 taxes would show that he made taxable gifts this year totaling $267,000.

Michael Sem is a tax analyst at CCH, a major provider of tax information and software. According to Sem's calculations, assuming your dad had never made any previous taxable gifts, his generosity would result in a gift tax bill of $76,580.

But instead of writing the government a check in that amount, $76,580 would essentially be subtracted from your dad's allowable gift tax credit of $345,800, reducing it to $269,220. If your dad doesn't make any more taxable gifts, whatever credit remains will be applied to reduce any estate tax due at his death.

(If you're still with me at this point, BRAVO!)

Last but not least, everyone gets their own separate gift/estate tax credit. Your dad is entitled to an applicable credit of $555,800 and so is your mom. Which means they can each give away a substantial amount of money — $1 million apiece — while they're alive, tax-free (using up $345,800 worth of their credit) and still have some of their individual tax credit left over at death to reduce estate taxes. Or, they can hang on to their assets while alive, but each leave up to $1.5 million in property at their deaths — a total of $3 million — and not pay a dime in estate tax. Or use a combination of gifting and bequeathing.

In other words, if your parents' assets are structured so that each of them can take full advantage of his/her own "exclusion" amount of $1.5 million (this year and next), they may be able to avoid estate tax entirely. Furthermore, under the 2001 Tax Act, the amount each of us can leave at death is going to continue to increase. It's slated to hit $2 million in 2006.

However, the amount you can transfer while you're alive, is not going up. Cumulative taxable gifts in excess of $1 million will result in gift tax. As the estate tax exclusion increases, "the split between the taxes due on gifts versus estates is going to widen," says Bruno Graziano, an attorney and Senior Analyst at CCH.

Which is why some experts think you should think twice before you give away assets under the new law. The reasoning goes like this: If you can avoid tax on a larger amount by waiting to transfer property at death, why transfer ownership — and lose control over the assets— before then?

From your description of their situation, it sounds as if your parents do need advice about how to take full advantage of the new gifting and estate tax rules. And it doesn't appear that housing prices in California will cool off anytime soon. So the value of their estate could increase significantly due to their real estate holdings alone.

My suggestion is that you start with an experienced estate planning attorney. But don't let your parents go alone. If they approve, it's probably a good idea for you to accompany them. It sounds as if you will end up handling their estate at some point and you need to be as comfortable with the advice they're getting as they are.

You're a good son!

Best wishes-



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The views expressed in this article are those of Ms. Buckner or the individual commentator, and do not necessarily reflect the views of Putnam Investments Inc. or any of its affiliates. You should consult your own financial adviser for advice regarding your particular financial circumstances. This article is for information only and is not an offer of the sale of any mutual fund or other investment.