When you are planning your estate, you may be concerned about the estate tax and the impact it can have on your legacy. Fortunately, it will not apply to most estates because there is an exclusion that can be used to transfer a significant amount tax-free.
At the time of this writing in 2022, it is $12.06 million, and the maximum rate is 40 percent. This is the highest we have ever seen, and it exists because of a provision in the Tax Cuts and Jobs Act (TCJA) that was enacted in December of 2017.
It will remain at this level indexed for inflation annually until 2026 if there are no legislative actions in the meantime that alter the trajectory. On January 1, 2026, the provision in the TCJA that established the record high exclusion is going to sunset.
The exclusion will revert back to the level that we had in 2017, which was $5.49 million, and there will be an inflation adjustment. In addition to the estate tax, there is a gift tax, so the exclusion applies to lifetime gifts along with your estate.
Additional Gift Tax Exclusion
There is an annual per person gift tax exclusion that is separate from the unified gift and estate tax exclusion. It was $15,000 per year, per person prior to this year, but it was raised to $16,000 for 2022.
To be clear, there is no limit to the total amount you can give tax-free as long as you do not give more than $16,000 to any one individual. If you are married, you and your spouse could combine your respective exclusions to give up to $32,000 annually to any number of people.
This can ease your estate tax burden. To provide an example, let’s say that you have three married children. You and your spouse could give a total of $32,000 to each husband and each wife, so as a couple, you could transfer $192,000 tax-free every year.
In addition to the tax-free transfers, you would be reducing the overall value of your estate. Direct giving is one way to utilize this annual exclusion, and there are others, so the sustained utilization of the annual exclusion will be part of an estate tax efficiency plan.
With this in mind, you have a limited opportunity to utilize the large exclusion before it is dramatically reduced in 2026. We can gain an understanding of your position and make recommendations with regard to the optimal estate tax efficiency strategy.
There are a number of different irrevocable trusts that can used to mitigate your estate tax burden, and one of them is the qualified personal residence trust. You fund the trust with your home, and you establish a period of time during which you will continue to live in the home as usual.
This is referred to as the “retained income period.” When you are drawing up the trust agreement, you name a beneficiary that will inherit the property after the expiration of the term.
The home is no longer part of your estate for tax purposes when you sign it over to the trust. However, the transfer to the beneficiary will be a taxable act of gift giving.
Since the beneficiary will not have control of the property for a number of years, the value of the gift is not equal to the fair market value of the property. The IRS takes this to account when they determine the taxable value, which will be well below the actual value.
Another strategy that can be quite effective when interest rates are low is the “zeroed out” GRAT approach. To implement this plan, you fund the trust with appreciable assets, and you name a beneficiary that will inherit the remainder that may be left in the trust after the term expires.
Once again, you are transferring the assets out of your estate, but you are setting up a potential transfer to a beneficiary, so the gift tax can be applicable.
The IRS calculates the taxable value of the gift by applying anticipated interest that will accumulate over the course of the term. They use the Section 7520 rate, which is 120 percent of the federal return rate. This is sometimes referred to as the “hurdle rate.”
You set up the trust to provide you with distributions that will equal the entire taxable value that has been established by the Internal Revenue Service. If the appreciation exceeds the hurdle rate, there will be a remainder in the trust after the term expires. The beneficiary would inherit the remainder, and the gift tax would not be a factor.
These are two of the trusts that can be used to gain estate tax efficiency, and there are a number of others, including the generation-skipping trust, the irrevocable life insurance trust, and the charitable lead trust.
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