… but when it does pay off, the reward can be substantial.

By Rick Waechter, Founder

Last week, we published a blog outlining attractive strategies to reduce your lifetime tax bill. This is Part 2, offering additional strategies. If you did not see that blog, click here, or visit the blog page of our website for that and other great blogs, here.

As mentioned last week, there are plenty of steps someone can take to reduce their tax bill for the current year. Heading into Q4, people will be mulling these, and we will speak with each of our clients about their unique situations. Strategies may include a large charitable gift, using their retirement account to make a qualified charitable distribution (QCD), tax-loss harvesting or bumping up their retirement contribution.

But the most lucrative tax strategies are different. They are more complex. They almost always take years to play out. Sometimes there is an up-front investment. Sometimes you face a risk that the strategy may fail. But in all cases, the benefit can be significant. If you haven’t thought through them, there is no time like the present to start.

Below are attractive strategies, in addition to those described last week.

If You Have a Large Individual Stock Position (Perhaps Employer Stock): Move Concentrated Stock Position into an Exchange Fund

• Background: Many people, especially senior executives in publicly listed companies, have a significant amount of their net worth in their company’s stock. This creates obvious risk. They may not be able to sell their shares during employment, and once they leave, the shares may have large unrealized capital gains, creating a potentially significant tax bill. Tax regulations allow you to contribute shares to a pool called an exchange fund. You have not sold, so there is no tax impact. You have not avoided the eventual tax. You have simply spread your risk among all the shares in the exchange fund.
• Strategy: Contribute some of your shares to an exchange fund, hold for the required 7-year period to achieve the full benefit of the structure, withdraw a basket of shares, and then hold those shares until your passing, avoiding all capital gains tax with the step-up at death. (See below for a discussion of the step-up at death.) You could have simply held your own concentrated position until death to avoid tax, but your risk would have been higher, owning just one stock instead of a basket.
• Downsides: To achieve the full benefit, there is a 7-year lock-up. You don’t know how the fund will perform relative to your contributed shares. An exchange fund charges an annual fee to all participants, and issues a K1, which complicates your annual tax filing.

After a Death and Have a Significant Net Worth: 706 Portability Filing

• Background: When someone passes away, the person administering their estate can file a Form 706 Estate (and Generation-Skipping) Tax Return. This is required if they passed away with an estate worth more than $15 mm. More than 99% of US estates will not be subject to this tax. But a surviving spouse can also use this filing to elect portability: the survivor can claim any unused estate tax exemption to increase the survivor’s exemption.
• Strategy: Imagine your spouse passed away with an estate of $5 million. You can claim portability of your deceased spouse’s unused exemption. In this case, it is $10 million, which increases your exemption from $15 million to $25 million. You may say, “I will never have an estate worth $25 million”. But what if the estate tax exemption is much lower when you pass away? Then you would still have your spouse’s $10 million unused exemption, even if yours is far lower. A reminder: in the late 1990s, the estate tax exemption was $600,000. Congress could reduce the exemption before your death to plug the federal deficit.
• Downsides: Filing Form 706 is a hassle, and if neither you nor your spouse eventually owe estate tax, the filing was unnecessary.

Planning to Maximize Benefit of Step-up in Cost Basis at Death

• Background: Current tax law allows someone’s heirs to “step up” the cost basis of an investment owned by the deceased to the value of that asset at the date of death. To illustrate, assume you bought a share for $10 many years ago, and it was worth $110 on the day before you died. If you sold the day before you died, you would have owed capital gains tax on the $100 gain. If your heirs sold it a day after you died, assuming the stock price remained at $110, they would have owed no capital gain tax. This step-up at death applies to assets in taxable accounts, not in retirement accounts. It applies to assets owned in a revocable trust but not in an irrevocable trust.
• Strategy: Own investments you expect to keep until you die in your taxable or brokerage account, especially if they have long-term growth potential and you have run out of room in your tax-free Roth accounts. Contrast the tax treatment with that of a pre-tax retirement account. All assets, including growth on them, must be distributed from a traditional retirement account during your lifetime or in the first 10 years after you pass away, and (typically) everything is subject to ordinary income tax rates.
  • • An enhancement: If you are married and one spouse is likely to pass away first, you can move assets with the highest appreciation to sole ownership of the spouse likely to die first. If that transfer happens at least one year before death, the cost basis steps up at that person’s passing, and the survivor can sell the assets after the death with no capital gain tax. Otherwise, a jointly owned asset would get only 50% of the step-up, unless you live in a community property state. This matters if the survivor needs the value of that asset to support their living expenses.
• Downsides: The step-up at death could be revoked by Congress.

If You Own a Large, Appreciated Investment and Like to Own Real Estate: Buy an Opportunity Zone Fund to Defer Some Capital Gains Tax and Avoid Future Capital Gains Tax

• Background: Congress passed a law in 2017, recently updated and made permanent, which creates Opportunity Zones. OZs are less economically developed areas where the government wants to promote development. Investors get two tax benefits for making qualified investments, typically real estate. First, you can sell an existing investment, roll the proceeds into an OZ investment, and defer tax on the capital gain for 5 years. When you do pay, the tax on gain is approx. 10% lower. Second, capital gain on the money invested in the OZ project is tax-free, if you maintain ownership for at least 10 years. Growth after 30 years is subject to capital gains tax.
• Strategy: Many investment firms have launched OZ funds, almost always for real estate investment. While the OZ legislation was intended to benefit underdeveloped areas, the reality to date appears to be investment in areas which are still attractive and growing – maybe not a bustling central business district, but not blighted or troubled geographies either.
• Downsides: These funds have fees and long holding periods, and there is no guarantee the returns will be attractive.

If You Are a Real Estate Investor and Don’t Need the Cash from a Sale: 1031 and 721 Exchanges

• Background: When you sell a real estate investment property, you can defer the tax on capital gain by purchasing a replacement property of the same or greater value. Many real estate investors use this so-called 1031 exchange repeatedly. It is not available for primary residences, and it does not avoid tax on capital gain – it just defers it until you sell the exchanged property. A 721 exchange is a 2-step transaction where the investor ultimately owns a partnership interest in a diversified basket of real estate properties instead of simply owning own property.
• Strategy: By combining a 1031 with a 721 exchange, you have diversified your risk and still not paid tax on unrealized gain. This may make it easier to hold the investment until you pass away, to achieve the step-up at death and full avoidance of capital gains tax.
• Downside: 1031 and 721 exchanges have detailed rules, for example a tight window for a 1031 exchange and minimum holding periods for 721 exchanges. There are initial and ongoing fees, which can be significant. When you exchange into a new property, there is no guarantee it will be a good investment.

If You Own a Valuable Residence and Are Worried about Estate Tax: Create a Qualified Personal Residence Trust (QPRT)

• Background: Congress allows the creation of a qualified personal residence trust (QPRT) as a vehicle to move a property out of your estate without selling it, while still being able to live in it for a predetermined number of years. If the home appreciates in value between the time of gift and your death, that appreciation remains out of your estate and not subject to estate tax. This is a strategy to reduce potential estate tax.
• Strategy: This is particularly appropriate with a house you believe will appreciate significantly before you pass away. That probably means you are young enough for the house to have decades to grow in value.
• Downside: The gift of the property to the trust is irrevocable, which means you must leave the home after the term ends. If you do not outlive that term, the transaction unwinds, and the property goes back into your taxable estate. A QPRT is expensive and complex to set up. If the house value does not go up meaningfully before you pass away, the QPRT was not worth establishing, and you lost the potential capital gains tax reduction from step-up at death.

We hope you find at least one of these strategies interesting. Questions? Please reach out.