(Photo Details:  Home sweet home.  According to the Wall Street Journal today, “slightly more than half of all assets owned by the bottom 50% of households comes from real estate.”)


Even though I was a tax professional for many years, this estate planning technique came as a shock to me when I read it yesterday in the Wall Street Journal (you may have to be a subscriber to see that link.)  For those of you who were not tax accountants, here’s some background before I get to the punchline:

Estate Tax

Most people won’t pay an estate tax when they die.  Estates receive an exemption from tax which is adjusted for inflation each year.  For 2019, for example, if you die with $11.4 million or less in assets, you will owe no estate tax. 

When you are married, and you inherit the estate of your spouse when he or she dies, this exemption isn’t even relevant yet, because you can inherit an unlimited amount from your spouse and not pay estate tax.

Then, when the second spouse dies, (again assuming 2019 exemption numbers), you don’t just get an $11.4 million exemption, you can get double that—$22.8.  You get your own exemption and also the exemption that kind of travelled with your deceased spouse’s assets that you previously inherited.

Which means most of us do not pay estate taxes.

Step up in Basis

But wait, there’s more. When you die, the tax basis of your assets gets “stepped up” to the fair market value of those assets on the day you died.  So if you purchased Apple stock a zillion years ago for 50 bucks a share and it’s worth $250 the day you die, your heirs can sell it for $250 and pay NO capital gains tax.  If you had sold it while you were alive, you would owe tax on the $200 of gain.  So your heirs stand to inherit more if you don’t ever sell it because no one ever has to pay tax on that gain.  The taxable gain basically disappears.

All of this I already knew.

Now the punchline

What never occurred to me was this (from the Wall Street Journal article, in case you can’t read the link):

It means the optimal tax strategy for the very rich, fine-tuned and promoted by the wealth-planning industry, is straightforward: Hold assets until death, borrow against them for living expenses and barely pay income taxes.

When your children inherit those assets, they can sell, them pay no tax, and use the proceeds to pay off your loans. Remember, those loans were just your living expenses, which would be gone from your estate anyway because you needed that money to live. The only difference is the interest (and of course the absence of capital gains taxes.)   Depending on your tax rate, the interest rate, and the length of time those loans were outstanding, this might save you and your heirs more in taxes than it cost you in interest.  Not to mention, the assets you didn’t sell can still be appreciating. 

The Downsizing Trend in Retirement

Which brings me to your house.  A typical retirement planning technique is to sell the big house you raised your kids in and go buy a smaller, less expensive house, maybe even in a lower-cost locale. Then you can use all that great home equity you amassed to fund your golden years.

But there is a cost to that plan, and if you live in a state where housing has appreciated dramatically over those years, it might cost you quite a bit.

If you are married and you sell your house, you will probably qualify to exclude up to $500k of the gain on that sale of that house.  So if that’s as much gain as you have, this downsizing plan might work as advertised.

But if your gain is a lot more than the exemption, it’s worth running the numbers to see if it might just be cheaper to stay put and take out a reverse mortgage.  The house continues to appreciate, you and your heirs escape capital gains tax completely, and you were able to get the cash out to pay for living expenses while you were alive.  Just like, apparently, the rich and famous are doing with their estates.

Of course, if you really want to live somewhere else, don’t do something just because of tax reasons. Last time I did that, it didn’t work so out well.

As to whether this is how our tax laws should work, well that’s beyond the scope of this blog post. But you can weigh in on that in 2020.


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Related Posts:

            Penny Wise and Pound Foolish (or Stupid Tax Tricks)

            Two Dumb Financial Decisions I Made

            Three Ways Your Home Can Fund Retirement



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