If you are looking to create or update your estate plan, you will want to understand how capital gains tax can affect your estate planning strategy. Failure to take capital gains tax policy into account can result in unexpected tax bills for your heirs when you finally pass your assets to them.
What is capital gains tax?
The tax charges that you owe on an investment after you sell is the capital gains tax. How much you are taxed depends on how much the value of the investment has appreciated. The amount you are taxed on this appreciation will depend on current law and your own circumstances. The higher your income, the more your capital gains tax rate will be.
Long-term vs. short-term
Aside from your income level, how much capital gains tax you pay will depend on how long you held onto the asset before selling it. What is considered long-term capital gains will be taxed differently than what is considered short-term. Assets held for less than a year will be considered short-term which means the gain in appreciation will be counted as ordinary income for federal tax purposes. In other words, short-term capital gains will be more costly to your estate and therefore you should take this into consideration in your estate planning strategy.
Trusts mitigate capital gains tax liabilities
One common and effective method of avoiding unnecessary capital gains tax liabilities is through the use of trusts in your estate plan. Trusts do provide some discount on capital gains taxes if the trust strategy is implemented properly.
Trust planning for real estate
There are certain capital gains tax rules when it comes to leaving real estate to your heirs. In some cases, you can save your beneficiaries from paying unnecessary capital gains taxes when they sell the inherited property later. Putting real estate in a trust can give your heirs a step-up in tax basis which means that capital gains tax liabilities will be calculated based upon the value of the property when your heirs inherit the property as opposed to when you purchased the asset. This can save your beneficiary significant money if the real estate asset has appreciated in value since you purchased it.
Section 1031 Exchange
When you sell a home outright you will incur capital gains tax, but there is a way you can avoid or delay a tax bill through the use of what is known as a Section 1031 Exchange. This IRS rule allows you to sell a property and then transfer your lower tax basis to the new property which can save your heirs significantly on capital gains tax charges when they eventually sell the property.
Which capital gains tax strategy is best?
Your personal circumstances and family financial planning goals will determine which capital gains tax strategy is right for your estate plan. Consulting with a professional wealth management advisor can be invaluable in helping you figure out the best way to mitigate capital gains tax liabilities for your heirs. A good financial advisor can also help you implement your plan once you have decided on your preferred generational wealth strategy.
The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete, it is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation. Any opinions are those of the author and not necessarily those of Raymond James. Expressions of opinion are as of this date and are subject to change without notice. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Raymond James and its advisors do not offer tax or legal advice. You should discuss any tax or legal matters with the appropriate professional.