Let’s change the facts a bit.  What if Al entered the nursing home but died before needing Medicaid.  At the time of his death he owned the home with Betty and Carl joint tenants with right of survivorship.  This means that Betty and Carl by operation of law received Al’s interest and now owned the home together.  No problem, right?  Well, not so fast.  We have to consider estate and inheritance taxes. 

Estate taxes are owed on estates over a certain size.  In the case of federal estate tax this year there is no estate tax and next year tax is owed on estates greater than $1,000,000.  New Jersey imposes a tax on estates greater than $675,000.  Al only owned the home, worth $600,000, and a few thousand dollars that he hadn’t yet spent towards his long term care.  Since his share of the home is worth $200,000 we don’t have to worry about estate tax.

New Jersey, however, also has an inheritance tax.  This tax is based first on the relationship of the heirs to the person who died and then on the amount received by that heir.  Children, grandchildren and spouses are exempt from the tax, but siblings are not.  The first $25,000 is free of tax but then the tax rate starts out at 10% and eventually reaches a maximum of  15%.  The tax is due 8 months after death and if not paid incurs interest at 10% per year.

Betty and Carl owe approximately $8000 each in tax.  Most people are unaware of this tax unless they have consulted with an estate or elder law attorney.  What happens if they don’t have the money to pay the tax?  The interest can start to really add up.  And if Betty and Carl need long term care themselves the tax can eat up what they have left in assets.  If Denise is aware of the tax and comes to see us before Al dies we can plan for the payment or possibly avoid it altogether until the last sibling dies.  If she waits till Al dies the choices are much less appealing.

 We are now 7 months into the year, the first estate tax returns for those who died in 2010 are due in less than 2 months, and still nothing concrete from Washington.  Many estate plans have built in flexibility in terms of placing assets into trusts to take advantage of the tax laws.  The problem is that if we don’t know what tax law is in effect how can anyone know what choices to make?

 The latest word is that a reinstatement of the old law is unlikely.  At least that is what Senate Finance Committee Chairman Max Baucus of Montana said last week.  Democrats want the reinstatement of a $3,500,000 exemption.  Republicans want to eliminate the tax entirely.  That would certainly be welcome news to families such as that of the late owner of the New York Yankees, George Steinbrenner.  Neither side has the votes to get what it wants, however, a compromise that is now being floated may be good news for all.

 Congress could permit more modest estates to elect to benefit from the step up in basis rules that were in effect last year.  This would mean, for example, that if you inherited, at your dad’s death, his house or stocks that he held for many years, the basis for calculating capital gains tax is not what he paid but the value of the assets at the date of his death.  So, if you sell those assets shortly after his death you owe no capital gains tax.  This way, the 2010 law would benefit everyone, not just the wealthy.

 While this makes a lot of sense, as we all know, that isn’t going to be enough to carry the day.  Lawmakers will be taking their traditional summer recess in a few weeks.  It’s not clear whether anything will happen but this all should come to a head in the next several weeks.  Stay tuned.

What Joe was talking about is inheritance tax.  Only a handful of states have it and New Jersey is one of them.  Inheritance tax works differently than estate tax, which is based on the size of the estate.  Inheritance tax, on the other hand, is based on the relationship of the heirs to the decedent (person who died).  Parents, grandparents, children, grandchildren, spouses and domestic partners are exempt from the tax.  So are stepchildren, but not stepgrandchildren.  Siblings, sons in-law and daughters in-law pay tax at one rate and other more distant relatives and non-relatives pay tax at another rate.

Inheritance tax is due 8 months after death, one month before the estate tax is due.  In cases where both estate and inheritance tax are due, the total combined tax is not greater than the larger of the 2 taxes.  In essence, if inheritance tax is due then that payment acts as a credit towards the estate tax.

Joe, like most people, was unaware of inheritance tax.  It is typically owed on estates where there are no spouses or children.  In his case, the tax totals about $13,000 and if not paid, carries 10% per year interest rate.  There are other quirks in terms of what is taxed and what isn’t.  For example, life insurance isn’t subject to the tax if you’ve left it to named beneficiaries.  However, if those people all have died, for example, and the insurance is left to the estate, then it is taxed.  However, the life insurance is subject to estate tax .  It is easy to get tripped up by which assets are taxed for inheritance, and which for estate tax purposes.

The point is that each estate has to be looked at individually.  Just because your friend or neighbor didn’t have to pay inheritance tax doesn’t mean you don’t have to.  I explained to Joe that we still have time to complete the return and pay the tax on time.  The last thing he wants is the state coming after him for unpaid tax.

What hasn’t been talked about much is that the same law that wipes away estate tax also has eliminated the step up in basis. If, for example, you inherited at your dad’s death his house or stocks that he held for many years, the basis for calculating capital gains tax was not what he paid but the value of the assets at the date of his death. So, if you sold those assets shortly after his death you owed no capital gains tax.

Now, however, there is no step up in basis. Instead, the first $1.3 million in capital gains will be excluded from tax ($3 million for assets transferred to a surviving spouse). More Americans will pay this new capital gains tax, however, than will avoid estate tax. That’s because with a $3.5 million exemption last year most Americans never would have paid any federal estate tax. It is estimated that 6000 estates will avoid estate tax in 2010 that would have paid tax based on the 2009 exemption. However, 71,000 estates could face a capital gains tax. Very simply, wiping out estate tax benefits the wealthy. Needing to offset the loss of tax revenue, Congress has instead imposed a new tax on less wealthy Americans.

Congress attempted to amend the law to make the $3.5 million exemption permanent but couldn’t get it done before the end of year. Talk of passing this amendment in 2010 raises other issues about whether Congress can role the clock back and apply the law retroactively. And for many states, New Jersey and New York included, there is still a state estate tax to contend with. Finally, the elimination of federal estate tax is for this year only. Without further changes, the estate tax comes back next year on estates over $1 million. So for most Americans, at best, they won’t feel any effect from the elimination of a tax they never needed to concern themselves with in the first place. At worst, they face a new capital gains tax they wouldn’t have had to pay under the previous law. Just another tax bite for the average American.

First, a little background. Under the previous law, Congress permitted a dollar for dollar credit towards the federal estate tax for any state estate and inheritance taxes paid up to a certain limit. So, many states established their estate tax structures to ‘soak up’ the maximum credit that Congress permitted. In essence, the federal government shared a portion of its tax revenue with the states. When it raised the federal exemption, however, Congress decided it could no longer share a smaller tax revenue with the states so it phased out this credit. Many states, in response, changed their tax laws to preserve their revenue stream. New Jersey now has an estate tax that kicks in on estates greater than $675,000 and New York on estates greater than $1,000,000.

New Jersey’s estate tax starts out at 4% and gradually increases to a maximum of 16%. New York’s estate tax also maxes out at 16%. As I explain to our clients, we usually see federal estate taxes in the six figure to seven figure range and state estate taxes in the tens of thousands of dollars on the low end, and hundreds of thousands of dollars on the higher end.

What can you do to reduce, or even eliminate this tax? Well, for starters, in the case of married couples, a bypass or credit shelter trust should be employed. This will save substantial amounts of tax that would be paid by children at the death of the second parent to die. But you must have this trust set forth in your will before you pass away.

What if that opportunity has already passed? Purchasing life insurance to pay the tax is another solution, which may be especially desirable where the estate consists of real estate that the family doesn’t want to sell just to pay the tax. And, placing that insurance in a life insurance trust is usually a good idea. Otherwise, you end up paying estate tax on the life insurance that you bought to pay the tax in the first place.

Ever since Congress passed the current estate tax legislation in 2001 it was the belief of many, including myself, that legislators would have to go back and pass changes to the law before 2010.  You see, in 2010 there is no federal estate tax.  But, the elimination of the tax applies only to that one year.  In fact, in 2011 the federal exemption, the amount one can pass free of federal estate tax, goes back to $1,000,000.  It doesn’t take much imagination to see why that can be a dangerous thing. A little explanation is required.

            In 2001 the federal exemption amount was $675,000 and heading towards $1,000,000 by 2006.  President Bush came to office having promised during his presidential campaign in 2000 to push for legislation eliminating the estate tax.  However, he couldn’t get his bill passed through Congress and had to reach a compromise.  That is why the current law gradually raises the exemption until, in 2010, the tax is eliminated.  But, the law contains a ‘sunset provision’, meaning it expires on December 31, 2010.  The previously law becomes effective once again.  Bush intended to go back and eliminate the tax permanently after midterm Congressional elections, which he hoped would increase the Republican majority in Congress.  As we all know, 9/11 and the Iraq war changed everything and in the last year the economy has sunk into recession.

            The federal estate tax is a pretty hefty one.  The tax rate is 45% so the tax can very quickly reach six and seven figures.  So, if Dad dies in 2010 there is no tax, but if he dies in 2011 the tax can be hundreds of thousands or millions of dollars.  Legislators often change the tax laws to influence public behavior.  We make so many financial decisions based on the tax impact (too many, in my opinion).  So, what will happen if families know that they can save millions in taxes if Mom or Dad dies on December 31, 2010, rather than January 1, 2011? 

            That is one reason why I always felt that change would happen before 2010.  Well, we’re 6 months away and still, no change.  Last year there was some talk about extending the exemption through 2015 at $3,500,000.  With the economy worsening, and government deficits increasing, however, that doesn’t seem likely.  The latest proposal is to put the exemption amount at $2,000,000.  But what if change doesn’t happen this year?  Can the law be passed after the beginning of next year?  Experts believe it can because estate tax is due 9 months after death, meaning the first 2009 returns are due October 1, 2009.

            Things will certainly be interesting so stay tuned.  And keep in mind that even if your estate is below $1,000,000 many states have their own estate tax which kicks in at amounts lower than the federal exemption amount.