Today we continue our discussion of issues related to Wealth Distribution, the third and final stage of what we call The Wealth Cycle. Get caught up on the series with the links below.
Read the Previous Posts in This Series:
- Phase 1: Wealth Creation
- A Wealth Creation Story
- Phase 2: Wealth Preservation
- On Preserving Wealth and Managing Risk
- Phase 3: Wealth Distribution
- Building a Cohesive Wealth Distribution Plan
- Case Study: Wealth Distribution Strategy
- Understanding the Step-Up Rule
- The Community Property Step-Up
Wealth distribution is all about your plan to distribute the assets you still own after your last ride around the Sun. Even though you won’t be around to deal with it all, poor preparation for that inevitable time can leave your heirs with a real mess on their hands, especially in the case of larger estates that may be subject to the Estate Tax rules.
Also known un-affectionately as the Death Tax, the Estate Tax is a tax on the net value of your estate above a designated threshold or exemption level. Currently, that stands at approximately $13,610,000 for individual estates and $27,220,000 for joint estates. The estate tax rate is 40%. So, if you have an individual estate valued at $20,000,000, your estate would pay $2,556,000 in Estate Tax (40% of the difference between $20,000,000 and $13,610,000). Ouch! However, for estates valued below the current thresholds, there are actions that can be taken to make sure assets flow to heirs without complication. However, these thresholds are going to be much lower beginning in 2026 when provisions of the Trump era tax cuts sunset. More on that next week.
In our previous two posts, we have focused on the Step-Up rules, whereby those who inherit an asset, get a step up in basis to the market value of the inherited asset at the time of decedent’s death. So, if you bequeath an asset you acquired for $1,000,000 that is worth $5,000,000 on the day you die, whoever you give the asset to has a basis of $5,000,000 and could sell the asset for that price and pay none of the taxes you would have had to pay if you sold the asset while you are alive.
Furthermore, if your spouse survives you (or vice versa) and you reside in one of the 9 remaining community property states, of which California is one, you or your spouse would receive a full step up to current market value and could immediately sell that same $5,000,000 asset and pay nothing in taxes. Needless to say, that is one whopper of a tax benefit, and makes clear why playing the “Step Up Game” is a widely utilized estate planning strategy.
Tax law also allows you to distribute all or a part of your estate by bequeathing assets to heirs before you die, but it comes at a price. If you give an asset to an heir while you are alive, they keep your basis rather than getting a new one at fair market value (the step up). There is no tax due at the time the asset is given, but the current value of the asset goes against your estate tax exemption threshold.
Let’s take a look at a scenario involving community property held in a joint estate. Say a man and his wife, both in their early 70’s, have an estate with a net value of $25,000,000 most of that concentrated in 3 commercial properties they bought in North Orange County back in the early 1990’s when North Orange County buildings were selling for $50 per square foot. They are now worth $400 per square foot. They worked hard running their business out of one of the buildings and acquired the other properties for investment when the market was at the bottom of a down-cycle. Smart folks.
Fast forward to the present day. The husband passes away unexpectedly due to complications from a minor surgery. Fortunately, the couple had a good estate plan that was properly constructed to take advantage of the rules regarding community assets. The wife was never hands-on in terms of managing the portfolio and is not interested in doing so going forward. Since she got a full step up in basis on their community assets, she could give them to her heirs immediately and their basis would be equivalent to her new stepped up basis. Or, she could sell her assets at her new basis and simply distribute the proceeds to her heirs without any state income, federal capital gains or estate tax (since the joint estate value is below the estate tax threshold). Essentially, she could set aside what she needs to live her lifestyle of choice, then complete the distribution of the estate to her heirs while she is alive to see them enjoy their inheritance, eliminating the hassle of managing her assets in the process, all thanks to the community property rules we enjoy here in California.
Now, this example is simplified to introduce the concept. Each and every action taken should be closely scrutinized be the appropriate legal and accounting professionals to make sure that your interests are fully protected. We can handle the real estate side of the equation for you and work closely with your trusted advisors to make sure that you get an optimum result.
However, as we noted above, the estate tax exemption threshold rules are reverting to much lower levels in 2026. This is a call to action for many of our clients to mitigate the impact of the new rules and is also the topic of our next post. Stay tuned.
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