The IRS recently announced the 2018 estate tax exemption and annual gift exclusion amounts, and both are rising due to inflation. As a background, the federal government imposes a tax at death of any US person who has at least $5,000,000, as adjusted for inflation. To prevent people from sidestepping the estate tax, the federal government also imposes a gift tax. However, there’s a realistic possibility that the 2018 estate tax rules could end up being irrelevant if President Trump’s administration is successful in implementing its GOP tax reform framework.
This discussion focuses on the federal estate tax laws, not the Oregon Estate Transfer Tax, which is in addition to the taxes discussed below.
Estate tax exemption
The estate tax is meant to levy a tax on wealthy Americans who transfer money and property to their heirs. For this reason, there is a certain value of assets per person that can be excluded from the estate tax calculation each year and this amount is periodically increased to reflect inflation.
For 2018, the estate tax exemption is $5.6 million per individual, a $110,000 increase over the $5.49 million 2017 exemption. Since this exemption is per person, married couples can exclude twice this amount, or $11.2 million. Any amounts in excess to this amount is taxed at a 40% tax rate.
The estate tax exemption amount doesn’t just pertain to money and property that passes to your heirs after you die. It also includes taxable gifts. For example, if an unmarried individual gifted $5.6 million during his lifetime and passed away in 2018 with $1,000,000 in assets, the deceased individual would have used up the allowable tax exemption during his lifetime and would have to pay taxes on the $1,000,000 in his estate at the time of his death, although he may not have needed to pay gift taxes during his life due to the application of the available credit.
Annual gift exclusion
The federal government allows a donor to gift up to a certain amount each year to each recipient without the donor needing to file a gift tax return. This amount was initially set at $10,000 but has been periodically increased for inflation. For 2018, the annual gift exclusion is increasing for the first time since 2013 to $15,000 (previously $14,000). This means that wealthy individuals can give away up to $15,000 to each recipient in 2018 without affecting their estate tax exemption.
This limit is per recipient. In other words, individuals can give as many $15,000 tax-free gifts as they want in 2018. If a wealthy individual has three children and seven grandchildren, they could give away as much as $150,000 of their wealth to those recipients, which will be excluded from their taxable estate. Married couples get an annual gift exclusion for each spouse, which means that a married couple could give tax-free gifts of as much as $30,000 in 2018 to whomever they choose.
Taking advantage of the annual gift exclusion every year can be an effective strategy to avoid estate taxes. The taxable portion of an estate is effectively taxed at a 40% rate, so if the annual gift exclusion is used by an individual to give away $1 million over a series of years, it could potentially save this individual’s heirs $400,000 in estate taxes.
Gifts in excess of $15,000 in a given year are taxable for estate tax purposes, and will reduce the giver’s exemption once they pass their assets to heirs. For example, if a certain individual gives a total of $100,000 to their child in 2018, their estate tax exemption will be lowered from $5.6 million to $5.5 million as a result.
GOP tax reform framework
The Trump Administration has proposed killing the federal estate tax, although the Administration has not proposed eliminating the gift tax. In 2013, only 4,700 estates were taxable at the federal level.
However, there are many unknowns in the Trump Administration’s proposal, most notably is the interplay with the elimination of the tax and capital gains taxes. Currently, almost all of a person’s assets can be sold the day after that person’s death without a capital gains tax. If the federal estate tax was eliminated and the favorable capital gains treatments was also eliminated, it’s possible that the federal government would bring in more revenue without the estate tax. For ease of explanation, here is an example:
Paul buys an apartment complex for $100,000 in 1970. Forty years later, he still owns it and it’s worth $4,000,000. There are a number of different tax consequences when the property is subsequently sold or gifted.
- Paul gives the property to his daughter, Molly. Because it’s a gift, Molly’s basis in the property is $100,000. When she sells it, capital gains taxes are imposed on the difference between $100,000 and $4,000,000. Assuming a 15% tax rate, the tax bill for federal purposes is $585,000.
- Paul sells the property for $4,000,000. Assuming a 15% tax rate, the capital gains tax bill is $585,000.
- Paul passes away and the property is transferred to his daughter, Molly. When Molly sells the property for $4,000,000, no capital gains taxes are due because of the current tax laws allowing the basis to be increased to fair market value as of the date of death.
It’s possible that the Trump Administration will advocate for killing the federal estate tax and will also advocate for denying the favorable basis increase (capital gains treatment) for assets received after someone passes away.
At this time, the “for-sure” changes are simply increases in exemption amounts due to inflation. However, if the Trump Administration is successful in destroying the federal estate tax, many estate plans will need to be reviewed to determine whether the documents should be re-drafted to reflect the changes in tax law.