Bloomberg recently reported that the Bill and Hillary Clinton planned to avoid estate taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. es by transferring their New York home to a residential trust. Their plans to avoid estate taxAn estate tax is imposed on the net value of an individual’s taxable estate, after any exclusions or credits, at the time of death. The tax is paid by the estate itself before assets are distributed to heirs. es are notable because of their political support for those taxes. But it’s also an excellent example of the arcane and complex nature of the estate tax and how simple reforms help to mitigate the complexity.
In April, New York passed a reform package that increased the estate tax exemptionA tax exemption excludes certain income, revenue, or even taxpayers from tax altogether. For example, nonprofits that fulfill certain requirements are granted tax-exempt status by the Internal Revenue Service (IRS), preventing them from having to pay income tax. amount from $1,000,000 to the $5,250,001 federal threshold. This 2014 reform decreased Empire State’s estate tax burden and diminished some of the same tax incentives that caused the Clintons to form residential trusts in 2011.
Shifting a property to a residence trust is a typical strategy used to avoid the estate tax. Instead of transferring a residential property upon death (which would trigger the estate tax), an individual can transfer that property to a trust, as a delayed gift. However, gifts don’t escape the estate tax by themselves; they are subject to the gift taxA gift tax is a tax on the transfer of property by a living individual, without payment or a valuable exchange in return. The donor, not the recipient of the gift, is typically liable for the tax. after you use up a certain lifetime exemption (which is equal in value to the estate tax exemption). A residential trust is a crafty way to reduce the amount of gift tax exemption you use up.
Here’s how it works: for a designated time period, the original owner retains the right to live in the home and its assessed value is frozen. After that period, the property is finally transferred to an heir and it counts towards the lifetime gift tax exemption at the original assessed value, not its current market value. In other words, all of the appreciation on the property escapes the gift tax.
For example, imagine that you have a $100,000 property in 2000 that appreciates to $110,000 by 2010. You want to give it to your heir in 2010. If you just give it to your heir, it counts as $110,000 against the exemption. If you plan ahead and put it in a residential trust in 2000, only its nominal value from that year ($100,000) counts against the cap.
When the Clintons created the trust in 2011, their property’s assessed value was $1.8 million. Without a residential trust, the future appreciation between 2011 and 2021 would count against the gift tax. If the property appreciated at a 4% annual rate and reached $2.6 million by 2021, that’s the amount that would count. With the residential trust, though, the Clintons were able to “lock in” the value of the home at its 2011 value of $1.8 million without actually relinquishing the property to the beneficiary of the trust.
The Clintons’ example supports what we’ve previously written about estate taxes – that they fail to collect significant revenue and mainly serve to support a cottage industry of tax planning – resources that could better be used in the productive economy. New York’s tax reform frees up those resources by reducing the incentive to do these sorts of tricks. With the higher exemption, fewer New Yorkers will plan around their state’s estate tax.
For more on estate taxes, see here and here.
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