The below is for informational purposes only, it is not tax advice or recommendation. Please contact your licensed tax advisor if you have specific questions.
Real estate is one of the most common assets to be handed down through inheritance from generation to generation. On average, American retirees leave an inheritance amount of $177,000, including real estate, to their loved ones whether it be children, spouses, or someone else.
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You may be inheriting property as part of a family member’s inheritance plan or decide to leave yours to someone else, in which case inheritance taxes may apply. It’s in your family’s best interest to understand the basics of inheritance tax and find out what they could be liable for after you are gone.
The majority of people that inherit property don’t need to be overly concerned with inheritance taxes. There are some cases where it will not only be applicable but be completely unavoidable too. The vast majority of estates in the US do not pay federal estate taxes, for example, and these taxes are primarily aimed at the estates of the overtly wealthy, trying to curb inequality. There is also more than one type of tax that can be applied to inheritance properties, which can make the process of filing much more convoluted than you would expect.
If you’re inheriting a property in the future or are planning to leave yours to one of your loved ones, you’ll want to read this article first. We’re breaking down everything you need to know about inheritance taxes and how you can minimize them as much as possible
Inheritance Tax Basics
It’s key to know the basics of inheritance tax before deciding which method of tax-saving is best for your estate or the estate of your loved one. In the US, there are twelve estate tax brackets, which can range between 18% and 40% depending on the location of the property that is being inherited.
Generally, estates that range from $0 up to $10,000 are taxed at the lowest base level of 18%, and any estates exceeding $1 million are taxed at the maximum amount of 40%. These brackets are applicable to both inherited real estate and inherited funds and are shifted yearly to new amounts.
At present, roughly two out of every 1000 estates are liable for the estate tax, and these taxes are only due on the portion of the estate’s value that exceeds the current set exemption level.
Beyond federal estate tax, the majority of states have their own inheritance tax policies, some of which have been controversial and heavily debated in the past. Opponents of this tax see it as a punishment on success, while its supporters see it as a necessary safeguard against inherited plutocracy.
The federal estate tax is applied to the taxable estate of every decedent that is a citizen of the United States. Real estate, in this case, is valued based on the fair market value it held at the time of the owner’s passing – fair market value refers to the price the property would sell for on the open market. If the inherited property is left to a spouse or charity that is recognized on a federal level, this tax is usually not applicable.
These taxes may sound expensive for both grantors and their heirs, and they can be. Luckily there are several ways to limit the costs and reduce them to a reasonable range. For example, every American is entitled to exclude a portion of their assets from their taxable estate, also commonly known as a lifetime exemption. The applicable credit amounts that are available against gift tax and estate tax for US citizens was equivalent to $11,400,000 of value in 2019.
There are also other methods of saving on taxes that grantors and heirs should consider carefully when structuring their inheritance plan.
Create A Trust
If you are setting up inheritance with a family member, a good course of action if you want to save on inheritance taxes is to set up a trust. A trust is a legal document that leaves specific instructions as to how the assets of the grantor are to be distributed to their heirs. This trust enables the passing of assets to beneficiaries without having to deal with the probate process.
When a property is in probate, the distribution of the property is overseen by the court following the death of the owner. The probate process includes having to evaluate left assets, paying remaining expenses from the estate, and completing handling before the heir can take possession of the property.
Trusts act similarly to wills, but because they skip probate requirements they can also reduce the associated time and expenses that come with going through the probate process. There are two types of trusts that are commonly used, revocable and irrevocable trusts. In revocable trusts, the grantor can remove and add assets as needed, while an irrevocable trust leaves assets untouchable until the grantor’s passing.
There are several benefits to making use of a trust – you can put conditions on how the estate will be distributed after you die, better protect your assets and name a successor trustee in case you become unable to manage them.
A basic trust plan can cost between $1,600 and $3,000 depending on the complexity. These plans typically include a will, living will and health-care proxy to start. You will also need to pay if you want to make changes to a revocable trust.
When it comes to protecting their assets, many individuals are tempted to set up joint assets with their children, but this can lead to increased inheritance tax. With joint asset ownership, the assets can be at risk should any of the joint owners become involved in a lawsuit, if they have any outstanding debts and if they were to divorce their spouse the property could be taken too. It also leads to higher taxes, especially if the property increases in value from the time the inheritance is structured to the time of the grantor’s passing.
Set Up A Family Limited Partnership
Another option for saving on inheritance tax is known as a family limited partnership. Family-owned assets like real estate can be put under an established family limited partnership, a strategy that involves creating a general partnership and in which grantors and heirs are both categorized as limited partners. Having multiple partners take ownership of the property will reduce the overall size of the estate and lower the inheritance tax significantly.
Individuals that are part of family limited partnerships can also gift interests tax-free once a year to other partners up to the annual gift tax exclusion amount. The gift exclusion at present is around $15,00 for individuals and double that amount for married couples. There are many benefits to setting up a family limited partnership, such as easy transfer in case of the death of a partner, tax income advantages, simplified real estate planning and protection from any creditor claims. It is important to bear in mind that a family limited partnership will affect capital gains taxes.
The cost to set up a family limited partnership can cost between $5,000 and $10,000 to start with additional ongoing expenses. This type of partnership can also lead to lower income taxes. If your descendants are partners, the total family taxes will decrease as they own part of the company. This does not, however, apply well to situations where one of the family members is under the age of 18. This is because as a minor, their interests would have to be held by a guardian, and to form part of the partnership they would have to play a role in the day-to-day management of the business.
Establish A Qualified Personal Residence Trust
A Qualified Personal Residence Trust (QPRT) removes your home from your collective assets while you still live there. In essence, it allows you to put your home in a trust for a period of between 10 and 15 years – after this period it passes to the possession of the trust beneficiaries.
The biggest benefit of a QPRT is the decrease in value which affects taxable amounts, with the continued use of the property, and the ability to avoid gift tax liability for passing on your residence. This works as QPRT’s effectively leverage your real estate tax exemption and reduce the value as a “gift”, decreasing the total taxable amount that heirs are liable for.
If you wish to remain in the property for longer than the term period, you can make arrangements to pay rent to the heirs. If the grantor passes away before the term is over, however, the property is included in the grantor’s general estate as if there had been no QPRT. This method is a big commitment – an irrevocable trust like this cannot be canceled and the terms cannot be changed.
Another thing to bear in mind is that QPRT income and expenses are taxed to the grantor, and not the heir. If the property is not maintained well, you could lose the QPRT protection you were looking for in the first place. QPRT’s can also be expensive to establish as the costs include attorney fees, appraisal fees, property titling costs, and more.
Inheritance tax can be a particularly complicated issue, especially when it comes to bigger estates made up of less liquid assets such as real estate. There are federal taxes, normal income taxes, and capital gains taxes to contend with, and altogether this can quickly become expensive for you or your heirs. When deciding how you want to structure the inheritance of your estate, you may want to seek the advice of a qualified estate planning attorney for further assistance.
You’ll want to remember that inheritance tax laws, exemption amounts, and estate tax limits can change over time, so there is some unpredictability that may affect these basic guidelines. However, following some of the strategies in this article will allow you to save on inheritance taxes significantly even if some of the financial details change.
Final Thoughts
The bottom line is that there are ways to reduce the cost of inheritance tax – it’s all about doing your homework, communicating with your family members openly, and choosing the option that works best for your estate.