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- [00:00]
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Foreign.
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Okay, what is up? And welcome back, everyone, to another episode of the Practical Planner podcast. I'm your host, Thomas Kopelman, and here with me again is Rachel Hartman. Rachel, thanks for joining me today. Really excited to kind of use your whole knowledge base and really start to think through capital gains tax planning. And I think really the best place to start this conversation is just thinking through. How do you. How do you really think through the difference between capital gains tax planning and estate tax planning? Because in certain situations, right, you're giving up one. Right. With certain irrevocable trusts, we're saying, hey, we'd rather avoid the estate tax than have the step up in basis. Or there are certain times where we're saying the opposite. So how do you even start this conversation or start thinking about how to prioritize one versus the other?
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So it mostly depends on where the client is located. So if I were to start, you know, I'm based out of Pennsylvania. Pennsylvania, we don't have an estate tax, but we have an inheritance tax. So it's just another level of tax that, you know, even if I can get out of federal estate tax, I'm still going to always have inheritance tax. So even though typically you might want to start off saying, is my client above or below the federal state tax threshold? You also have to think of, well, if my clients in a state that has state estate tax or inheritance tax, how does that play into it as well? Because it's not always just as simple as looking at that 1399 and going above or below that.
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B
So in Pennsylvania, so let's say you're getting this, you have this inheritance tax. You know, how would you plan around that for some specific client? Because I think it becomes hard of, like, where's the parent? Right? So like, let's say the parent is in a state that doesn't have that. Or like, what if they're in New York, right? And so New York, they have an estate tax, and then the kids live in Pennsylvania and then they have an inheritance tax. So could they be hit, like, multiple ways from this?
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So inheritance tax is only on the resident of Pennsylvania. So even though it's called inheritance, you don't get hit on it for being in Pennsylvania and inheriting.
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Hmm.
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So we would just be in. So you would be parents in New York, they leave money to their kid in Pennsylvania, there isn't the tax then, but once the kid then passes away, then all of those assets are subject to inheritance tax.
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I see, I see. Okay. So when we're thinking about this conversation, we think about two things, right? So first is like, where are you in the estate tax threshold? And that's hard because ages matter, right? Like if, if you're at 10 million but, you know, you're single and you're 85 is different than you're 10 million at 40. Right. But then, so you think about this and say, okay, if I'm 10 million at 40, I'm gonna work for a long time. I'm probably gonna cross 15 million in the next five to 10 years. I do need to think about it. But then it also, you have to go to the next step and say, well, what are the type of assets that I own? Right? Like if you're a founder and you potentially have a ton of stock in your company, you might be a better situation to really think about estate tax plan to say, okay, let's seed some of my company stock in a trust. Because I think this is going to grow a ton. It can stack USBs, and that's going to be more beneficial than that step up in basis versus somebody who might be, hey, I'm 10 million, I just retired, I'm going to have a lower growth portfolio, you know, but it may already have quite a bit of growth. They might be thinking, okay, I'm probably not going to cross the threshold. And if I do buy a little bit, I'm actually probably better off to think about step up in basis than I am to think about the estate tax.
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Yeah. So I'd say that the, like, the standard is always, if you have these, you know, high appreciating assets that you really expect are going to grow, you always want to try to get them out of your estate sooner rather than later. Whenever they're low, they have a low gift value for gift tax purposes. You get them out into either, you know, a grat into some other sort of irrevocable trust, get them in the hands of your beneficiaries. So then later, whenever you, you know, do pass away and they have that high value, they're already in the hands of the bennies. But I guess that it's twofold because, you know, you have to look at what do I want to happen to these assets ultimately? Do I think it's a business that my kid's going to hold onto, or do I think it's something that's going to get in the hands of my kid and they want to sell it? And then, so whenever they sell it, then you say, well, because this was already gifted, it has the gifting basis at the time it was gifted on the gift tax return as opposed to getting a step up in basis whenever you pass away. So it's one of these, you know, what is the asset, how, how much is it going to grow to, what do I want, what do I want my child to do with it? But also what do I think they're going to do with it also?
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Yeah, and it's one of those things that like we all as advisors preach compound interest. Right. And so like your point here of like how early can you get high growth assets in there is extremely important because let's, you know, even the example of like you put $100,000 of your, you know, new C corp that you launched, maybe, maybe less, let's say you're a few years in, so it's 100,000, but now you're going to run that for 30 years. Right. That 100,000 could end up becoming, let's say $10 million. You only had to use a tiny bit of your exemption if, if any, depending on how this is structured with the beneficiaries are, et cetera, to then get $9.9 million out of your estate. But on the flip side, if you didn't do that and you passed away with that 10 million, you avoided the capital gains tax on that amount. So it's, it's like so hard to really make these decisions when people are young because one, you don't know where the estate tax is going, right? Everybody's been saying it's going to get reduced forever and it keeps getting increased. You don't know what's going to happen to that company. This example I'm using, what if, you know, you end up seeding quite a bit into it but the company never amounts anything and now you paid for your revocable trust, you know, you use some exemption, got nowhere. You know, there's so many variables to think about here that I feel like it can be really hard for people to end up actually making the decision.
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100% and that's why it's always, you know, my preference. So I just put pen and paper, say this is what it's worth now, this is what it could be and this is worst case scenario. And kind of just model out those three pass. And just keeping in mind what would capital gain tax look like in the client's hands or my hands, what would it look like in my kids hands versus estate tax. And you kind of stop to just there's not one size fit all. You got to sit down, run the numbers and Just see what makes the most sense for you.
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Yeah, because I guess if you think about it too, right? Like what if you see this asset but then it does get sold? So now you get hit with the capital gains tax, you're most likely seeding it into a state with no state tax would be my guess, right? So you're still probably paying this 23.8% capital gains tax inside of that trust. You did get a good amount of money out of your estate, but you never get that capital gains avoidance either. So it's different with potentially public equities or potentially an ETF that you know that is always going to be valuable because then you really have this decision of do I realize capital gains or do I not? And I think one thing that would be helpful for maybe some of the advisors here listening is to just get an understanding of like, okay, so most assets get a step up in basis when they're in your name, right? So the property that you own, you know, most investments that you own, most businesses, I guess not all, but most. But what about with irrevocable trust, right? Do all irrevocable trusts avoid a step up in basis? Do some of them get a step up in basis?
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So for the most part, all irrevocable trusts, because especially if they're established by you, so you want to get these assets into these trusts to get them outside of your state, they are not going to be includable in your state, so they are not going to get a step up in basis. However, if you have an irrevocable trust where you retain a general power of appointment, that is something that would then make it includable back in your state, which we don't have to get into the nuances of that. So just to say that 95% of the time, if you have an irrevocable trust and it's outside of your state, it's not going to get a step up in basis.
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And isn't one thing to talk about here, and I wonder if you're familiar on this, is you can have inside of these irrevocable trusts the ability to substitute assets, right? So yeah, so one way to really plan around this is, hey, you get a high growth asset in there, right? So maybe that's stacking QSPs, maybe that's just getting a lot of growth out of your estate, but you could then move in some other asset and move this out that would have a higher basis. So that way then these come out, this can have the step up in basis, the Other asset that goes in there, that step up basis would be less advantageous, but you've gotten more out of your estate for that. You know, what you put in.
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No, definitely. People do that. It's very common. And they'll most often, at least in my experience, they'll swap it out with cash.
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Well, I guess that makes total sense. Right, then you have no concern or anything about that step up in basis.
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Exactly.
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Okay, okay. So while as we just talk about step up in basis versus estate tax planning, what other things do we need to hit on?
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I mean, I would, I would say that, you know, I mentioned this earlier, but I do think that where you're at statewide is important because you might say, you know, I'm in, I'm in Washington. Washington's unique in that it has no income tax, it has estate tax, but it has a secret not, not so much anymore, capital gains tax. So you think, oh, I don't have any income tax. I don't have to worry about doing the trade off of capital gains versus estate, when in actuality it has a separate capital gains tax that it came, that they passed, I think about four or five years ago. So there's just sometimes like these little nuanced things to be aware of. So in addition to, you know, where am I at statewise and understanding that also just what sort of gain deferral or gain exclusions are there for me that I can use during life that might not exist, you know, from an estate tax perspective. So, so from there, whether we're looking at as basic as sale of personal residence, that having a gain, a capital gain exclusion to whether you want to do, you know, qualified opportunity zone where you have a capital gain and then you reinvest it so that you can defer the tax on that capital gain. And then similarly there's, you know, IRC 1031, licon exchanges, there's just a bunch of different, you know, gain exclusion or gain deferral that the, that the code gives you. And I always say that, you know, there's a lot of stuff in the Internal Revenue Code that people don't know about and sometimes they give you tools to help you. You just have to know where to look.
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Yeah, that's a really good point. That's some things that, you know, I have a few really high net worth clients that we're doing a lot of these type of strategies and talking about because, you know, for example, I work with somebody who's, you know, just under 100 million net worth and has tons and tons and tons of capital gains that they will be having because they're an investor. So one thing that we're able to do is how do we figure out and have the ability to drive tax losses, right? And so this is direct indexing, most likely long, short, direct indexing. And you can lever this up however much you want. But what's really cool about it is you can say, okay, I'm going to rack up as much losses as I possibly can, drive my basis down, knowing very well I'm never going to need to sell that money to spend. And then what happens is in the future you're going to end up getting this kind of step up in basis from it. And so that can be, you can be thinking about depreciation of properties, right? Maybe you're a real estate professional and you're saying it helps me to offset income tax now and I'll get a step up in basis. This could be just any investments that you have. Can we do tax loss harvesting, direct indexing, anything to drive down basis again, knowing that we'll have a step up in basis in the future. But I think it creates a lot of really cool planning opportunities when you think it's okay to have really low basis stuff, knowing that we can use the step up in the basis, step up in basis in the future versus sell and realize tax today. And I think a lot of people do make make tax mistakes by not thinking through like when can we realize this in a lower bracket. And that's why for high ear, you know, offsetting capital gains for you know, most my clients in California, they're paying 37% long term capital gains, right? 23.8 plus anywhere from 13, 3 to 14, 3 depending on their income. So how do we drive down and offset those today knowing that hey, we're going to retire in Florida. And in Florida I'm going to have a 15% capital gains bracket. Like that is a really big after tax difference by deferring in certain times.
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Paying in certain times no 100%. And also just again like in California, it's like worst case scenario Florida maybe best case here in Pennsylvania, you know, we're paying 3.07% on capital gains. Like it's not, it's not the end of the world. But I will say unique to Pennsylvania, a couple other states is we don't allow capital loss carryovers.
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So if you don't, that's super interesting.
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So yeah, so say you have, you know, a big loss this year, you put it on your tax return. If you Want to carry it carries forward for Fed, does not carry forward for state.
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So you'd want in that state be really thinking of tax gain harvesting. You'd say we might as well reset my basis because this cannot be carried forward and used.
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Yeah, exactly. You have to do kind of a cost benefit of it considering the lower 3, 3.7% income tax rate. But for the most part there's nothing worse than putting that loss on a tax return and just saying goodbye to it as you can't carry it forward the next year.
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Well, this is where planning becomes super interesting. Right. Because this example you're talking about is like, okay, so maybe you have a bunch of losses this year. Maybe we're doing long, short, direct indexing because you're going to have a capital gain event next year. But this year you're in 15% plus net investment tax. Next year you're going to be in 20%. So you'd rather those losses carry forward Fed wise because that's going to get 5% difference versus the three. And so you come out to a head. Yeah, I feel like this is where things get dangerous for advisors, where you really want to do tax planning for, but you really need to get into like the nitty gritty and the rules of each individual state. Like for example, I have a client who's in Massachusetts. In Massachusetts you cannot deduct the employer side of a 401k. So like my client is a solo 401k. They're putting 70,000 in that 46,500 employer side deduction does not work in Massachusetts, but it works federally. Like every state just has these weird random rules that they create for no reason. That can make things hard, but you really have to be aware of them before you kind of push somebody into a decision or a situation that was wrong.
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No, yeah, exactly. It's just so nuanced. It's so easy to get down into, into the weeds. But sometimes you just have to be. Cause there's just so many little things that can, they can quickly add up to.
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Yeah, okay. So when we think, I mean maybe recapping wise like estate tax planning, capital gains tax planning. So the ways to really plan around estate taxes, reduce estate taxes is really, you know, yearly gifting. Right. You know, where we have our 19,000 per person to as many people as we want. So getting money out that way, it can be super funding 529. It can be paying for, you know, parents, kids, etc. Health expenses or school expenses. Right. Those are easy ways to get it out. It can be using irrevocable trust to put low growth or high growth assets in maybe low basis ones. It could be substituting assets in so we can get that step up in basis. What else on the estate tax side did I miss?
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So we did. So we did. Yeah. So, so high appreciating assets going into trusts.
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Grats. I mean grats are just a good one where you don't use any of your estate tax threshold but you can get money out of your estate without using any. For a lot of high net worth people, I don't think they use them enough. Like it's kind of a no brainer if you have too much money. And I already have, you know, I was talking to a client that there's $21 million of Nvidia. Maybe we should probably, you know, use some grants on this Nvidia stock to get money out and, and help your kids. It could even be, you know, gifting kids to, to spend low basis stock. Right. So hey, your kids 21, they're going to start a business and they want to buy a house. Great. Instead of giving them 200 grand, you could give them 200 grand of stock with a $20,000 basis and they could sell that over a couple of years and use 0% long term capital gains bracket. So I guess that's kind of a mix of the two.
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Yes. I think the most important one like you mentioned there would be would be grats. I think that's the most, the most common and especially whenever I would say right around the time that the before we knew that the estate tax central was going to be extended, everybody wanted to make sure they're using their exemption. People ran out and then you just want to start doing grats because that's going to be for the most part a zero gift into the grab. But there's just, I think sometimes people find there's, it can be a little risky if they're, if they have older clients and they're worried they're not going to, you know, live through the term of the grant.
- [16:56]
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Yeah. Typically something to do like a little bit younger in their life and hope they make it through. Okay. And then on the capital gains tax planning side. Right. There's one like 0% or you know, tax gain harvesting when you're in lower brackets. It could be, you know, not gifting your house or gifting things to kids before you pass away because you get the stuff step up in basis. It can be tax loss harvesting. So that can be regular tax loss harvesting Direct indexing, long, short direct indexing. It can be using qualified opportunity zones. I would say like right now we're in this like terrible time of them because you're stuck in the old tax bill where if you do it now, it just defers to pay them in 2020, April, 2027, same thing next year. But then 2027 rolls around now you have these new five year rolling period. So I think it'll start to make sense then. What am I missing there?
- [17:48]
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Just other gain deferrals, like kind exchanges. So to the extent that you have, it's going to be, you know, like any sort of property held for business or investment. Say you have, you know, something as simple as a second home that you Airbnb and you use it for investment. Say you want to sell that and then buy a new property. You can then use those funds, defer any gain as you purchase the second property. And I've seen a lot of people just more recently with the, just the rise of vacation rentals, of just cycling those funds to keep buying new different properties.
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B
Yeah, agreed. I actually have so many clients who own short term rentals. It's just like super common to say, great, I have a liquidity event or something else. I'm going to buy a short term rental. My spouse is going to manage the entire thing. We're going to take, you know, active status there and use those losses to offset active income. So I think that's a really good one. You know, you can actually do that with, you can put in, let's say, hey, I have the same example Nvidia. I have tons of Nvidia low basis. There are ways to defer that into basically like an ETF that, you know, Alpha Architect has one where you basically feed it into there. And then now you're in this diversified portfolio. You still keep that low basis on the future when you sell, but it allows you to diversify without selling. You know, there's prepaid variable forwards which is where you borrow against that stock and then can go put it into a different one. And some people, high net worth people will put that into a long short direct index, rack up losses and then use those losses to slowly diversify out of that stock. I mean honestly, capital gains is, there's a lot that can be done. Like there are so many tools. But I think for most advisors it's understanding that like most of the tools are for the high net worth space. Like I see people are like, should I do this? I have a $300,000 capital gain it's like, no, you shouldn't. Like that is not enough tax to try to put yourself into some really complex tool. And even 1031 exchanges, I mean, can't tell you how many people have bought a terrible property just to defer the gain when they would have been better off to pay the tax and wait and buy the right property. That's a better long term investment.
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A
Yeah, no 100%. And I think also it's just important that you, like you said, 200, $300,000 of gain sounds like a lot, but whenever you do the math and then when you think of all the time, time and money you're either spending on planning or you're putting in a bad asset like it is. It's not that bad if you look at it as a whole.
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Yeah.
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Because last thing we do is have invest in something bad, then you're stuck with it.
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Yeah. I think that one of the biggest mistakes high net worth people make, or just people in general, is only thinking through the lens of tax. Right. Like tax is important, but after tax, wealth is the most important. So like, so the perfect example I think of this is so many people want to buy into oil and gas. Right. Because when you buy into oil and gas you get this weird tax law from like 1926 where you can just claim active status, but if you put this money in ensure you get the depreciation and you know, all that upfront. But if it returns 1% a year for 20 years, you're going to be way worse off than if you would have just invested it into the market or something else that's going to have sustainable, better returns. But a lot of people get this like shiny object syndrome. And it's the same reason why people buy a new truck every year to save on taxes when in reality they didn't need a new truck and they have less money at the end of the year anyways.
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Yeah, there's nothing that is, that annoys me more is when someone says they do it for the write off and it's like, well, you still have to spend the money to get the write off. Like do you realize how much you're spending just to save a marginal piece of that on tax.
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Yep, exactly. And the last one actually we didn't hit on is donating assets before selling them.
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Right.
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So donor advised funds, CRT, etc. Right. Like, you know, for most of my clients, they are going to sell a business or they have tons of equity compensation and maybe they're going to have a liquidity Event and retire. Those are really good periods of time to take care of the next 10 to 20 years of charitable giving. Donate the low basis stock. You know, you can do that on private or public assets, avoid that capital gain, get a deduction against your income and then you can still go and grow those assets or you can turn them into an annuity, depending on kind of what structure you use.
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Yeah, I think for the most part that was a big strategy. The past couple of years was just to donate those appreciated assets. And I think the clients more so understood that. You know, obviously the AGI limitations hit whether and that you have the lower agile limitations for deducting on your income tax return. But it wasn't necessarily to get the income tax deduction. It was to get rid of those high, those high assets while still meeting your charitable goals.
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Yep, yep, exactly. And it's like hard because they you have a higher standard deduction. So sometimes people are like, well if I don't have a mortgage and I don't have a lot of state taxes, then I won't be there. But now with higher salt cap, so you make 30, let's say 3 or 400k, you're gonna pick up more than 10k. And for a lot of people that are way above that phase out 600,000, charity is a lot more. Potentially they have, you know, 750,000 of a mortgage at 5 to 7%. That puts them way above. But even so, using a donor advised fund allows you to, hey, maybe I'll take the standard every four years and on the fifth year I'm going to do a donor advised fund contribution and then I'm going to go back and take the standard and it can lead to quite a bit in tax savings and capital gains avoided. And then take that cash, buy back that stock if you want and raise your basis.
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A
Yeah, exactly. Especially a few years ago whenever we had that, the limited time of the, the raised AGI limitation. Tons of clients at the time back in practice they were just selling everything and rebuying it and just resetting their basis. But that was for like one year.
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B
Might as well do that instead of use cash.
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A
Yeah, cool.
- [23:23]
B
Okay. Well I feel like that's everything that we needed to hit on today, Rachel. Appreciate you coming on again everybody. Thank you for listening again. If you have any topics you want us to talk about, feel free to reach out. But if you like the podcast, please don't forget to rate it 5 stars. Subscribe and share with another advisor who would like to learn more about tax and estate planning. See you back here in a couple weeks.