Providing for Your Heirs--Non-Sale Property Transfers

By Donald R. Levi.

Most non-sale real estate transfers made by owners of small acreages relate to a desire to pass on their estate to their heirs. Occasionally an owner may exchange his acreage for other real estate of like kind in order to avoid income taxes associated with an outright sale, but the typical non-sale transfer is to family members.

Basically, these transfers fall into two general classes lifetime gifts and testamentary bequests. Motivations for each may differ, partly depending on legal and tax considerations. These motives are better understood by considering the estate planning objectives of most persons.

Most persons have three basic estate planning objectives. First, they want to make sure they are taken care of during retirement. Second, they often desire to leave certain assets to specific relatives or friends.

Third, once the first two objectives are achieved, most want to minimize the expenses and taxes associated with transferring property to the next generation. Minimizing these costs maximizes the value of property transferred to heirs.

Most non-sale transfers of property are related to these estate planning objectives, so it is useful to briefly review them.

Retirement Security. Before Social Security, retirement security often was achieved through owning real estate. It was sold at retirement, with proceeds serving as the retirement nest egg.

Some still use this method. Usually they sell to non-relatives, but sometimes to heirs under a "family annuity" arrangement.

A real estate tract is transferred to children in exchange for the children's promise to pay the parents a fixed monthly sum for the remainder of their lives.

Many real estate owners prefer this to the regular life insurance annuity because a premature death would financially benefit their heirs rather than an insurance company. But it can result in both federal gift and income tax liability, so competent tax advice should be obtained.

Retirement security may also be obtained, singly or in combination, by maximizing Social Security benefits, or by participating in employer, self-employed, or "individual retirement account" retirement programs authorized by the Internal Revenue Code.

Distribution Preference. Once retirement is reasonably assured, most turn their attention to the desired distribution of property among children, grandchildren and others. Obviously, the preferred distribution is a highly personal matter, so it is difficult to make generalizations which apply to everyone.

However, a couple of observations are in order.

First, an equal distribution among children is not necessarily a fair distribution. The personal, health and financial situation existing for children and their families may affect distributional choices. So may the extent to which relatives and friends have been available and of assistance during times of need. Only the person concerned can make judgments on these matters.

Second, lifetime gifts are less popular than testamentary bequests with most elderly persons, because the former involves a loss of control before death. Thus, lifetime gifts take away assets which could have been used for retirement security. This, together with the fear that inflation may erode purchasing power of funds set aside for retirement, has the effect of discouraging lifetime gifts for the less wealthy.

One major advantage of lifetime gifts is that one knows the desired property distribution has been achieved, and that it will not be upset by a family dispute over validity of a will.

Legal fees and taxes associated with transferring property to heirs are referred to as "intergeneration transfer costs". They consist of legal and other fees involved with probating an estate, state inheritance taxes, and the unified federal gift and estate taxes.

Generally speaking, our goal is to minimize these costs while also achieving retirement security and desired asset distributional patterns. Clearly though, our major concern should be to minimize the total of all intergeneration transfer costs.

It is illogical to set up wills so as to save one dollar in probate expenses if this costs an additional ten dollars in federal gift and estate taxes. one reason for working with a competent estate planner is to avoid this trap.

Probate has several functions. It assures that the deceased person's debts are paid, and also makes sure that debts owed the deceased will be collected. It keeps title clear to real estate and other assets by specifically identifying all heirs and designating which ones inherit each asset. It assures that the deceased's wishes are carried out in distributing assets.

Probate Expenses

While there are some filing fees and advertising expenses in administering an estate, usually the major expenses are fees paid to the estate's personal representative (the executor or administrator) and the attorney hired to assist.

The personal representative and attorney normally receive fees of about equal size. In many states their compensation is set by state law and is based on a sliding scale that is, the percentage they are entitled to decreases as the size of estate increases. In other states the statutory compensation called for is a "just and reasonable" fee, which presumably depends on the amount of work actually required to administer the estate.

Other indirect costs may be associated with probate, such as lost profits suffered by a family business because probate constraints and red tape prevented sales and/or purchases to be made optimally.

An attorney can advise and assist you in preparing wills, trusts, and other legal instruments so as to avoid or minimize both direct and indirect probate expenses.

Most states have either an inheritance or an estate tax.

An inheritance tax is a tax on the right to receive property, and generally is based on the amount (value) of property inherited by each person. Many states provide tax-free exemptions for some specific value of inheritance.

Both the exemption size and the tax rate may vary, depending on the degree of blood relationship. That is, in several states lower inheritance taxes are due when property is inherited by close rather than distant relatives. To this extent these taxing schemes serve as an incentive to keep property in the family.

An estate tax is a tax on the right to transfer property. Therefore, it is based on the total value of property owned (or controlled) by the decedent. In general, the amount of taxes collected under state inheritance and estate taxes are not greatly different.

Federal Taxes

Generally, the tax bite is much more substantial at the federal level.

Since 1976, lifetime gifts and transfers occurring at death have been "unified" and are now cumulative (added together) for tax computating purposes.

That is, the value of taxable lifetime gifts made this year is added to taxable gifts made in previous years. The total tax due is computed on this sum.

Gift taxes paid in previous years are subtracted from the tax so computed, and the difference is the amount due and payable for this year. Thus, as additional taxable gifts occur over time, they are subject to progressively higher tax rates.

It is important to remember that the person who makes the gift, and not the person who receives it, must pay any federal tax due.

Similarly, federal estate taxes due after death on one's estate must be paid out of the estate. Further, property transferred at death is called the decedent's "last gift", and its value is added to any previous taxable lifetime gifts in order to determine the additional federal tax due at death.

Thus, all non-sale transfers of property both lifetime and testamentary are combined to determine the total federal tax liability assessed on the privilege of transferring property to the next generation.

The dollar figure used to compute the gift and estate tax due is fair market value. There is just one exception to using fair market value, and it is available only on transfers made at death never on lifetime gifts.

`Special Use' Value

This exception involves real property used in closely-held businesses, including family farms and ranches. If all qualifying requirements are met, then land may be valued at its "special use" (agricultural) value rather than fair market value.

Particularly in these areas where there is a large difference between agricultural and fair market value, qualifying for this special tax treatment may save many tax dollars. Such large differences most often are found near large urban areas because it is here that the fair market value of land may be driven up by a large number of buyers seeking to own a few acres near their jobs.

However, not all of these owners will qualify for this lower federal estate tax valuation. The basic intent of Congress was to make the use of agricultural value available only for family businesses which are going to be continued as a family business by the next generation.

Several technical legal tests have been developed to determine who is really a farmer. And total or partial recapture of any tax savings resulting from using agricultural value is required when the farm or ranch is transferred within 15 years of death to someone other than a qualified heir.

Unified federal gift and estate taxes are computed separately for husbands and wives. Thus, a simple way to begin minimizing taxes is to have ownership roughly divided equally between husband and wife, taking into account differences in life expectancies and recognizing that there are financial advantages to deferring tax payments until later.

To see that this division will help minimize taxes, just think of the assets held by a married couple as being represented by one large box. If all assets are owned by one of the spouses the taxes due on transferring the property to the next generation will be assessed on contents of the entire box. However, if the box can be divided into two parts with each spouse computing and paying taxes on their respective part, it is possible to stay down in lower tax brackets.

Splitting asset ownership into "two boxes" is encouraged by a preferential federal gift tax treatment (called a martial deduction) that is available. It lessens or avoids gift taxes on non-sale transfers between spouses, so that the "two box" scheme may be achieved at lower tax cost.

Gifts to charities are encouraged by federal gift and estate tax law since they are entirely exempt from tax. In addition, such gifts may also qualify for an income tax deduction.