Feature

DECLINING MARKET STRATEGIES

Gift Now, To Avoid Capital Gain Tax Later

Problem: In this declining market, there are some strategies which need to be considered to protect frompotential capital gains taxes in the future. We know that when we purchase an asset (real property, stock) our basis is generally the cost. If the market declines forcing the value of the asset downward, our heirs could have a problem since their basis becomes the fair market value on the date of the owner’s death. What if we gifted the asset presently? The tax law dictates that the recipient of the gift takes the donor’s basis in the asset called the “carry-over” basis.

Example: Jake, age 70, moved from Arkansas to California in 1986 and bought a home in Pacific Beach for $800,000. He also owns a ‘tater’ farm in Arkansas which he inherited at a value of $1 Million. Jethro, his only son, age 40, will be the sole heir of his estate. Because of the declining market, the home in Pacific Beach is now valued at $600,000 and that tater farm has dropped like a rock to the tune of $500,000. Both properties continue to decline in value. Jethro, who got some schooling at UCSD, begins to see the writing on the wall. If Papa Jake “kicks the bucket,” his new basis in these properties will be date of death value. If the market turns around during his lifetime, he could be in a world of hurt capital gains tax-wise. Jethro has been Californie-converted and he “ain’t keeping that tater farm” in Arkansas.

If Jethro can convince Papa Jake to gift him that farm and Pacific Beach property now, there would be a nominal amount of gift tax ramifications. Plus, Jethro would receive Jake’s carry-over basis of $1 Million on the tater farm and $800,000 on the Pacific Beach property. This would allow for a tremendous cushion if and when the market turned around to reduce the impact of capital gain. If Jethro can’t sell Jake on a present gift, he might have him amend his Trust to include authority for Jethro to act in this regard as the Successor Trustee should Jake lose capacity to act.

Let’s assume Jake agrees to the gifts of the properties.

The Pacific Beach property is appraised at $600,000 and the tater farm $500,000 on the date of gifting. For calculating losses, these values will be the new basis in the individual properties. However, for gain purposes Jethro obtains the original basis of $800,000 and $1 Million respectively. Jake subsequently dies when the Pacific Beach property is valued at $550,000 and the tater farm $450,000. If Jethro later sells the farm, his basis for loss is $500,000. As a result, he realizes a loss of $50,000 not $550,000 using the original basis. Jethro moves into the Pacific Beach home where he lives until the year 2015. Over the six year period the real property market has recovered (thank goodness) and he sells the property for $1.1 Million. His carry-over basis for gain is $800,000, Jake’s original basis. He realizes a gain of $300,000 of which he excludes $250,000 under IRC §121 as a resident homeowner. If his capital loss is still available from the farm he can use it against the $50,000 capital gain from the home.

What if Jake had not made the gifts prior to death? Jethro would have received date of death values of $550,000 on the Pacific Beach property and $450,000 on the tater farm. On the subsequent sales of the properties, Jethro would have realized zero loss on the sale of the farm and a whooping $550,000 gain on the sale of the home. What a difference!

Strategy: Consider gifting to heirs now to retain a carry-over basis for your heirs and/or amend your documents for this purpose pronto.

Husband-Wife: Might we have the same type of situation develop for couples? Under IRC §1014 both halves of community property will receive a step-up in basis on the death of the first spouse. Likewise, under IRC §1014(b)(6) both halves will receive a step-down in basis in a declining market on the death of the first spouse. This can place a surviving spouse with a number of years of life expectancy at a tremendous disadvantage. This becomes extremely important should one of the spouses have a terminal illness or dementia.

Example: Biff and Babs, ages 70 and 65 respectively, have been life-long residents of California and have had a home in San Diego for years. The home was purchased for $1 Million, their cost basis, but has recently declined in value to $750,000. They also have seen their stock portfolio decline from a basis of $1.5 million to approximately $900,000.

Biff has been diagnosed with early stages of dementia and has underlying heart problems. Babs is as fit as a fiddle and could easily live another 25 years as there is longevity in her family. They have heard that this declining market can place Babs in a difficult position should Biff die without further planning. They have a Living Trust and powers of attorney but seek advice on estate planning because of Biff’s condition. Their astute weight lifter, financial planner, Buff, recommends that Biff gift all of his interest in their assets to Babs via a special type of document called a Transmutation Agreement. Basically, the Agreement will transmutate all of Biff’s community property interest in the assets to that of Bab’s separate property under the authority of Family Code §852.

The Agreement is drafted by a knowledgeable estate planning attorney and signed before Biff loses capacity to act. Six months later, Biff has a massive coronary and dies. The home is then valued at $700,000 and the stock portfolio $800,000. Because of the effect of IRC §1014 (b)(6), Babs new basis in the assets would have reflected these values with a new low basis. However, because of the timely action the couple took on Buff’s advice, IRC §1014 did not apply because the assets had been transmutated to Bab’s separate property. As a result, Bab’s basis in the property remains their original basis of $1 Million on the home and $1.5 Million on the stock portfolio for capital gains purposes.

Ten years later, Babs sells the home for $1.2 Million realizing a $200,000 gain. However, her IRC §121 exclusion of $250,000 covers the gain and she pays no tax. If, however, the couple had not entered into the Transmutation Agreement, her basis in the home would have been $700,000 which would have caused a realized gain of $500,000. She would then have a recognized gain of $250,000 after the $250,000 exclusion under IRC§ 121.

Strategy: Consider a Post-Nuptial Transmutatuion Agreement if a spouse is terminal or having dementia problems. At least, amend your estate plan to provide for such an agreement should a spouse lose capacity to act.

Question: Do your documents, your Family Trust and Durable Powers of Attorney, provide authority for your fiduciaries to make gifts above the annual exclusion amount should you lose capacity to act? For maximum flexibility, they should.

Trust Tip: Amend your Trust and Durable Power of Attorney to allow your Successor Trustee and agent in your Durable Power of Attorney to gift assets in a declining market.

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DESIGNATION OF PROFESSIONAL ADVISORS IN ESTATE PLAN

Are you named in your client’s Financial Powers of Attorney and/or Living Trust as their financial advisor or CPA? If not, why not? If you have been professionally advising a client for years and developed a relationship with the client you should be specifically designated as the financial planner or advisor in these documents. Why? So that on the client’s disability, resignation as Trustee or death, you are designated to continue to manage the client’s portfolio or prepare tax forms for the client or estate.

Many times children of the client assume fiduciary positions such as Successor Trustee or Agents in Financial Powers of Attorney and transfer funds to their own advisor without restraint. They may be unaware of the professional-client relationship that has existed over the years with your firm, or they may just feel more comfortable with their own professional planners.

I find that it is worthwhile to retain the advisors who have rendered advice for years to the client and is familiar with the client’s investment philosophy. As a result, I include a provision in my Trust and Financial Power of Attorney which instructs the Successor Trustee or Agent to continue the investments or tax preparation with the person or entity designated in the documents. We then insert the name and address of the advisor. With this mandated instruction, the Successor Trustee or Agent under the Power of Attorney cannot freely transfer the funds to another financial planner or CPA without a prudent reason. Further, this agreement maintains continuity in the investment process and continues the policy and philosophy of the client. Talk to your clients about this arrangement and explain its benefits. If they agree, have them amend their estate planning documents to designate you by name to continue as the Trust’s or estate’s financial advisor or tax preparer. This may not absolutely prevent Successor Trustees or agents in Financial Powers of Attorney from transferring assets to another planner or tax preparer, but it certainly provides a reason not to take such action. Most fiduciaries adhere to the prinipal’s wishes and this is no exception.

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recent rulings

Estate of Kievernagel, 166 CA 4th 1024

Query: Is male sperm considered to be separate or community property? It probably depends on where it is located or deposited.

Husband and wife contracted with a fertility medical center to perform in vitro fertilization. As part of the process, the husband had to store a sperm sample in case his live sperm could not be utilized on the day of insemination. The agreement for the IVF back-up sperm storage included an option for sperm disposal to be discarded or donated to the wife. The husband initialed the box directing that the sperm be discarded. The wife signed the agreement to acknowledge that the sperm was the husband’s separate property. The husband subsequently died in a helicopter crash, and the wife became administrator of his estate.

In a petition by the wife to obtain the stored sperm which was opposed by the husband’s family, the Court denied the wife’s petition. The Court of Appeal affirmed the decision based on the intent of the husband and Uniform Anatomical Gift Act (Health & Safety Code §§7150-7151.40) which gives a person the right to make, revoke, or refuse to make a donation of any part of his/her body to take effect after death.

Might it be argued under a particular fact situation that the sexual act, which relocates the sperm into the female is, in effect, an inferred act of transmutation from the husband’s separate property to community property or the separate property of the wife? Just asking...

Transfers Between Spouses

Marriage of Brooks and Robinson (2008) 169 CA 4th 176 Husband and Wife were married in 1997 and subsequently acquired a home. The money for the down payment was paid from husband’s earnings but the wife took title as “wife, a single woman” for financing purposes on the advice of the real estate agent. In 2005, the spouses separated when the home was in foreclosure. A company who dealt in distressed properties acquired title from the wife based on the recorded deed, paying her $41,000. In the divorce proceedings, the husband attempted to set aside the transaction on the basis that the home was community property and had been transferred without his authority. The Trial Court ruled against the husband and the Court of Appeal affirmed.

The Court concluded that the home was the wife’s separate property based on the “form of title” presumption.

This doctrine provides that the description in the deed as to how title is held is presumed to reflect the actual ownership in the property. This presumption can only be rebutted by “clear and convincing proof.”

The form of the title presumption supercedes the presumption that property acquired during marriage is community property if a spouse acquires property in that spouse’s name alone and the other spouse has knowledge of the fact and does not object. Additionally, the form of title presumption cannot be overcome solely by tracing the funds utilized to purchase the property or by evidence that title was taken in a particular manner to obtain a loan without clear and convincing evidence otherwise.

The ruling also rejected the argument by the husband that the transmutation provisions of the Family Code were relevant requiring him to formally consent to the arrangement. The Court held that a transmutation is an interspousal transaction that changes the character of property that the parties already own. In this case, the property in question was being acquired from a third person which cannot be the object of a transmutation. To rectify this problem, spouses can undertake a post-nuptial agreement under California law.

Recommendation: To avoid this unfortunate arrangement, the spouses should have been advised to enter into a Community Property Agreement, specifying the home as a community property. This would have satisfied the clear and convincing proof required by the Court. We usually always include Community Property Agreements in the Estate Plan to clarify these very issues.

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q&a Section

Question:Can Irrevocable Trusts be modified or terminated under California law?

Answer: Possibly. Probate Code 15404 provides that the Settlor and all beneficiaries, by agreement, may modify or terminate a Trust without Court intervention. However, if a Settlor is no longer available because of death or incapacity, all the beneficiaries may petition the Court to modify or terminate the Trust under Probate Code 15403. However, if the continuance of the Trust is necessary to carry out a material purpose of the Trust, the beneficiaries must provide evidence that the reason for modifying or terminating the Trust outweighs the material purpose for continuing the Trust under its present terms.

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Trustee Trap

Avoid The Following Trustee Trap

Unamendable Trusts

Based on the current state of the law, we need as much flexibility as possible should changes need to be made in the Family Trust. It comes as a great surprise to many children that they are unable to amend their parent’s Trust when the Trustor becomes incapacitated unless the Trust and Durable Power of Attorney (DPA) provide such specific authority.

For instance, a single parent may have failed to amend his/her Trust to include specific provisions to protect the estate from complete spenddown under the Deficit Reduction Act (DEFRA) being adopted in California. This catastrophic health law provides for some exemptions to spenddown but such provisions must be implemented into the Trustee Powers. If this has not been accomplished and the Trustor/parent is now incapacitated, can the Agent in a Financial Power (hereafter DPA) amend the Trust for this purpose? Yes, if both the Trust and the DPA provide this authority. The Trust must state specifically that it can be amended by an agent in a valid DPA. Probate Code §15401 (c). The DPA must state affirmatively that the agent has the power to modify the Trust. Probate Code §4264(a).

Both documents must provide this authority or the agent is powerless to act. In demonstrating your understanding of the law, advise your clients to implement these powers in their documents.

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