By Cliff Taylor, Partner
In our 35 years of practice as financial planners and investment advisors, we have observed a few universal truths. Consistently topping that list is the fact that clients prefer to reduce taxes. This should come as no surprise; our country was founded in the cauldron of a tax dispute. Limiting one’s tax liability is part of America’s DNA.
The most common tax planning area for our clients over the years has been working to avoid the estate tax at both the federal and state level. This unpopular tax, also known as the “Death Tax” or “Inheritance Tax,” reduces the amount of assets passing to the next generation.
Historically, estate tax exemption limits were very low, but significant change has occurred in recent years. Since 2016, there is no longer a Tennessee state inheritance tax. The federal estate tax exemption in 2019 is $11.4 million for individuals and $22.8 million for married couples. These higher exemption levels have eliminated the need for complex estate tax planning for most Americans. However, the planning need for other kinds of tax liabilities, particularly capital gains, remains. Tennessee trust law has created a powerful tool to aid in reducing this type of tax.
In 2010, the Tennessee legislature enacted the Tennessee Community Property Trust Act, cementing our state as a leader in trust and estate planning. There are nine community property states, while the remaining 41, including Tennessee, are common law states. Community property gives equal ownership to both spouses along with an equal share of growth and income. Community property assets also receive a significant federal income tax advantage.
Upon the death of the first spouse, both spouses’ interests receive a basis increase to the current fair market value. This is a noteworthy benefit over the more common “joint tenancy with rights of survivorship” where only the deceased spouse’s half of the asset receives a step-up in basis at first death. A Tennessee Community Property Trust offers clients the benefits of living in a community property state without having to move.
As an example:
In 1998, John and Sue Smith purchased an office building for $500,000. Over the next 20 years, they received income, the building appreciated in value, and they took depreciation on their annual tax return. In 2018, John passed away with the building valued at $1,000,000 and the tax basis at $50,000. Under joint ownership, federal tax law allowed Sue to receive a step-up in basis on John’s half of the property value, or $500,000. Sue’s half will maintain its $25,000 basis, creating a total tax basis of $525,000 on the property. If Sue sells the building for $1,000,000, she will realize a long-term capital gain of $475,000 and will owe approximately $113,000 in capital gains taxes. If Sue and John had put the building into a community property trust prior to John’s passing, the property would have received a full step-up in basis at John’s death to $1,000,000, potentially eliminating the entire tax liability for Sue assuming the same sale price.
In this scenario, John and Sue might not have been in danger of an estate tax, but the creation of a community property trust may have allowed Sue the opportunity to sell the building tax-free at John’s death, providing her funds to meet living expenses, etc.
If a lower tax bill isn’t intriguing enough, additional advantages of a community property trust include:
- It is revocable, meaning assets can be pulled out of the trust at any time.
- At both the first and second death, trust assets avoid probate and any associated costs while keeping your financial information private.
- The trust can hold developed or undeveloped real estate, business interests, stocks, bonds, mutual funds, and many other investments.
- A community property trust can protect an asset from becoming a marital asset in a second marriage.
While not for everyone, a community property trust can be a useful planning tool, particularly for couples owning valuable assets with extremely low tax basis. A detailed discussion with a financial planner or tax professional can help you develop a tax-efficient plan for your assets, allowing your estate to pass efficiently to your heirs.
To start a conversation on developing a plan for your assets, contact us.
TrustCore is one of the largest independent wealth management firms in the U.S. From its offices in Brentwood, a suburb of Nashville, TrustCore advises on client assets of $1.8 billion for clients in 34 states across the nation.
Financial planning and investment advisory services offered through TrustCore Financial Services, LLC. Investments offered through TrustCore Investments, LLC, member FINRA and SIPC®. This is not an offer, or solicitation of an offer, to buy or sell any security investment or other product.