Arizona Elder Lawyer

Federal Tax Effect of Real Estate Gifts

The Wall Street Journal reported in its May 26, 2011 Personal Finance section that the IRS has embarked upon a “low-profile but sweeping effort” to uncover gifts of real estate that have not been reported.  This effort is generally going to uncover transfers made by do it yourselfers who think they are capable of creating their own estate plans.  Indeed, lawyers involved in these mechanisms for transferring wealth would either counsel against it or ensure that the proper tax forms were timely filed.  The middle class will bear the brunt of this effort by the IRS in large part because they do not realize that their actions are “gifts.”

The issue generally arises when a parent decides to “make things easier” by transferring title to real property to a child during the life of the parent.  In their minds, the transferor is not actually making a gift, rather, they are just “putting their children on title with them” to avoid legal fees later.  Individuals generally transfer title to real estate from themselves to them and others in joint tenancy.  The presumption is that the transferor will die first and that no problems could arise during their life.  This transfer is a gift upon the date the joint tenancy deed is created. 

I won’t get into the multitude of legal issues that can arise from these ill advised transfers other than the immediate issue which was raised in the WSJ article: gift taxes.  As the law stands today, a person may generally give property worth $5 million without paying gift tax.  The lifetime exclusion per person was $1 million through 2010.  However, any time a gift exceeds $13,000 to any person, the transferor is required to file a federal form 709.  Such form is generally filed at the time their income tax return is due.

Why is this important?  There are penalties for not filing the tax return timely, for valuation understatements that cause an underpayment of tax, and for willful attempt to evade or defeat payments of taxes.  See IRS 2010 Instructions for Form 709.

How is the IRS going about this quest?  In California, the IRS requested a “John Doe summons” be issued by a federal judge to the State Board of Equalization, a taxing agency.  The judge declined to issue the summons because the IRS had not demonstrated that the IRS could not get the data requested in a different way.  Apparently, court records indicate that Connecticut, Florida, Hawaii, Nebraska, New Hampshire, New Jersey, New York, North Carolina, Ohio, Pennsylvania, Tennessee, Texas, Virginia, Washington and Wisconsin have willingly handed over the information.  The report indicates that the data showed “an extremely high failure-to-report rate.” 

The best approach to address these issues is to actually file the requisite returns, even if they are late.  There are many capable tax and estate planning attorneys who can assist.  It is well worth the time and effort to hire one to do just that.

Trust Modification to Achieve Settlor’s Tax Objectives

During 2008 Arizona Revised Statute § 14-10416 was enacted.  In its entirety the statute provides:

“To achieve the settlor's tax objectives, the court may modify the terms of a trust in a manner that is not contrary to the settlor's probable intention. The court may provide that the modification has retroactive effect.”

Arizona Revised Statute § 14-10410(B) allows a trustee or a beneficiary to bring a proceeding in court to approve or disapprove a proposed modification or termination to a Trust.  The statute allows a court to wield broad discretion in these matters. 

A legitimate argument could be made that courts should not have this much discretion over an individual’s personal financial affairs.  Courts might take care to incorporate the settlor’s intent, rather than one “that is not contrary to” the settlor’s probable intent, even if the settlor’s intent might seem eccentric.

A contested proceeding should focus upon the intent of the settlor, whether or not the settlor was represented by competent counsel and other pertinent evidence. 

If all of the beneficiaries consent to modification or termination, a petition of this nature should be promptly approved by the court.  But, rather than summarily approving these petitions, courts might better serve the public by proactively scrutinizing who might actually be affected, their ages if they are alive, their current means and current vulnerabilities, their ability to truly understand what rights might be or are affected, and the values of the potential revisions to each affected beneficiary.  The consent of the living beneficiaries should be limited in application to their specific, personal rights. 

If not all beneficiaries consent, as long as the interests of the dissenting or silent beneficiaries are adequately protected, the court should promptly approve the petition so as not to impede the Trust administration.  Whether or not beneficiaries have been “adequately protected” will undoubtedly be vigorously contested by many.

This statute does not appear to have been tested yet in any published case.

Estate Tax Planning - Today

If there is no legislation passed in Congress related to the rules for 2010 and 2011, the Wealth Transfer Rules, as established, are as follows:

• Estate Tax Exemption:  in 2009: $3,500,000;  in 2010: unlimited;  in 2011: $1,000,000
• Maximum Estate Tax Rate:  in 2009: 45%;  in 2010: none;  in 2011: 55% + 5% surcharge
• Gift Tax Exemption:  in 2009: $1,000,000;  in 2010: $1,000,000;  in 2011: $1,000,000
• Maximum Gift Tax Rate: in 2009: 45%;  in 2010: 35%;  in 2011: 55% + 5% surcharge
• Generation Skipping Transfer Tax Exemption:  in 2009: $3,500,000;  in 2010: unlimited;  in 2011: $1,000,000 (indexed)
• Maximum Generation Skipping Transfer Tax Rate:  in 2009: 45%;  in 2010: none;  in 2011: 55% 

Why are there vast differences in amounts and percentages?  Simply put: politics. 

There are many extraordinary consequences which will come to light upon the death of loved ones as things stand now if Congress fails to act and people fail to update their written plans.  

For instance, Marital Deduction Formula Clauses, including very hard fought clauses during Pre-Nuptial and Post-Nuptial negotiations and planning, applied to different tax laws than originally intended can result in unintended results.  The effects might result in beneficiaries receiving unintended shares or unanticipated estate tax burdens, with others receiving nothing; none of which was the intent of the Trustor or Testator.  This might affect many spouses who are not the first spouse as well as children from prior marriages.  One can anticipate an upswing in litigation as a result. 

While it might be expensive to review legal documents for updates, particularly in troubled economic times and so much legislative uncertainty, it might be less expensive in the long run to go through a document review and update now.  When Congress affirmatively acts in this area of law, the documents will need further review. 

Individuals who take it upon themselves not to act are personally responsible for their choice.  No-one could legitimately blame their former estate planning or family law attorney for failing to advise them of information which has been so well publicized.  Such individual choices might impose unfortunate and unconscionable results on loved ones when they are already dealing with a death.  These consequences are already occurring.  Lives are being devastated, emotionally and financially, as a result.

State law might be used as a tool to correct these problems.  But those with a windfall might be inclined to litigate.  Those without their expected financial support might find themselves financially unable to participate in protracted litigation.  Prudence dictates specific, written plans to be reviewed, without delay.

Annual Federal Gift Tax Exclusion During 2010 – Update

The Internal Revenue Service just announced “Guidance For Persons Making Transfers In Trust After December 31, 2009” in Notice 2010-19. 

 

The Notice states that the Internal Revenue Service intends to issue guidance under Section 2511(c) of the Internal Revenue Code.  The Code Section was enacted in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) and amended by the Job Creation and Worker Assistance Act of 2002.  Section 2511(c) is effective for transfers made after December 31, 2009, and before January 1, 2011.

 

“Section 2511(a) generally provides that the gift tax shall apply to transfers in trust or otherwise, whether direct or indirect. Under § 25.2511-2(b) of the Gift Tax Regulations, a gift is complete when the donor parts with sufficient dominion and control as to leave in the donor no power to change its disposition.

 

"Section 2511(c) provides that, notwithstanding any other provision of section 2511 and except as provided in regulations, a transfer in trust shall be treated as a transfer of property by gift unless the trust is treated as wholly owned by the donor or the donor’s spouse under subpart E of part I of subchapter J of chapter 1.

 

"The Joint Committee on Taxation’s explanation of 2 section 2511(c) provides that certain transfers in trust are treated as transfers of property by gift even though such transfers would have been regarded as incomplete gifts, or would not have been treated as transfers under the gift tax provisions in effect prior to 2010. Joint Committee on Taxation, Technical Explanation of the “Job Creation and Worker Assistance Act of 2002” (JCX-12-02), March 6, 2002.”

 

The Notice provides the following Interim Provisions:

 

“Some taxpayers may have inaccurately interpreted section 2511(c) as excluding from the gift tax transfers to a trust treated as wholly owned by the donor or the donor’s spouse under subpart E of part I of subchapter J of chapter 1, even though those transfers would otherwise be taxable under Chapter 12. The provisions of Chapter 12 regarding the substantive law applicable to the gift tax were not amended by EGTRRA, and those provisions continue to apply to all transfers made by donors during 2010.

 

“Section 2511(c) is an addition to those substantive law provisions and is applicable to transfers made in 2010. Section 2511(c) broadens the types of transfers subject to the transfer tax under Chapter 12 to include certain transfers to trusts that, before 2010, would have been considered incomplete and, thus, not subject to the gift tax.

 

“Accordingly, each transfer made in 2010 to a trust that is not treated as wholly owned by the donor or the donor’s spouse under subpart E of part I of subchapter J of chapter 1 is considered to be a transfer by gift of the entire interest in the property under section 2511(c). The provisions of Chapter 12 as in effect on December 31, 2009, continue to apply (both before and during 2010) to all transfers made to any other trust to determine whether the transfer is subject to gift tax.”

 

Regulations are expected to be forthcoming which confirm the conclusions set forth in the Notice.

Federal Gift Tax Exclusion For 2010

On October 15, 2009, the Internal Revenue Service announced that the annual gift tax exclusion for calendar year 2010 remains unchanged from the 2009 amount at $13,000.  See IR-2009-093.  

In December 2009, the Internal Revenue Service updated its own Publication 950 and stated “in 2010, any transfer of money or property in trust is a taxable gift unless the trust is treated as wholly owned by the donor or the donor’s spouse.” 

The Internal Revenue Service elaborated that the general rule is that any gift is a taxable gift.  The tax is owed by the donor, not the recipient.  In addition to the annual exemption, gifts not subject to the gift tax include gifts to your spouse, gifts to a political organization for its use, tuition or medical expenses you pay directly to an institution for someone else’s benefit, and gifts to charities.

If you have questions, it is wise to seek the advice of an attorney who is knowledgeable in this field.

Estate Tax Update

While the Estate Tax has effectively been repealed for 2010, some elected Democrats have declared that the Estate Tax, otherwise known as the Death Tax, will be retroactively reenacted. 

Without Congressional action, the Estate Tax will automatically revive itself in 2011.  The highest Estate Tax rate will be fifty-five percent.  The exemption will be only $1 million dollars. 

An notable difference is that carryover basis rules will apply rather than the step-up basis rules that have been in place for many years.  This change will be a rude awakening for the heirs of those who were told that they did not have to save old records if they planned to die with certain assets.  The old records no longer exist as they were purged years ago.  If you can’t prove something was paid for or be able to prove the amount paid then the IRS may take the position that there is a zero basis. 

There is likely going to be some change in this arena during 2010.  Or not.