Massachusetts remains a member of the minority of states that imposes its own state estate tax.  While the federal estate tax impacts a small minority of estates, Massachusetts has a filing threshold of $1,000,000.  When adding in the value of a home, life insurance, retirement accounts and other assets, many individuals can easily surpass this filing threshold.

In addition to the assets that one owns on their death, its important to remember that this filing threshold includes “the adjusted taxable gifts made by the decedent after December 31, 1976.”  See Massachusetts Estate Tax Instructions Form M-706 at page 2. 

Thus, while the property gifted by the decedent during lifetime is not subject to the estate tax, the value of the gifted property may increase the property subject to the state tax at death.  Nonetheless, in many cases lifetime gifting may reduce the estate tax paid to Massachusetts at death, subject to one giant caveat in regards to income taxes, explained below.

Examples illustrate this.  In this case, we have a single individual with no out of state property with a taxable estate of $1.8 Million.

Example 1:  The individual passes away owning all property at death, having made $0 gifts during lifetime.  Since the assets of the estate ($1.8 Million) exceed the filing threshold of $1 Million, the estate must file a return and the Massachusetts Estate Tax is $85,200.

Example 2: The individual passes away after having gifted $700,000 of assets during lifetime leaving them with $1.1M of assets on death. Since the combined assets of the estate ($1.1 Million) and the adjusted lifetime gifts ($700,000) exceed the filing threshold of $1 Million, the estate must file a return and the Massachusetts Estate Tax is $38,800.  The lifetime gifting in this case reduced the Massachusetts Estate Tax by $46,400.

Example 3. The individual passes away after having gifted $900,000 of assets during lifetime leaving them with $900,000 of assets on death. Since the combined assets of the estate ($900,000) and the adjusted lifetime gifts ($900,000) amount to $1.8 Million, they exceed the filing threshold of $1 Million and the estate must file a return.  The Massachusetts Estate Tax is $27,600.  The lifetime gifting in this case reduced the Massachusetts Estate Tax by $57,600.

Note that in these examples it is only “taxable gifts” that determine whether the estate is over the filing threshold.  Therefore gifts made using the annual exclusion or payments directly to the provider of educational or medical services for a third party do not impact the filing threshold. (And before you dismiss these as trivial amounts, consider how much property a grandparent could remove from their estate by paying for college expenses for their grandchildren).
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Lastly, the caveat: income taxes.  Arguably one of the most powerful provisions of the entire US Tax Code is section 1014, commonly referred to the step-up in basis provision.  When you inherit property from someone at their death you do not inherit their tax basis in the property, rather your basis is determined by looking at the property’s fair market value at their date of death (with some exceptions).  Whereas if you transfer property by lifetime gift, the recipient receives your tax basis in the property and will receive no adjustment to basis on your death.  While reducing estate taxes is a worthy cause, no estate tax planning can be done without careful consideration of the recipient’s income tax costs when they later sell the property or through loss of depreciable basis in the property.  A recent analysis we did for a client showed that lifetime gifting could provide estate tax savings of $50,000, but that it would generate $300,000 of additional income tax costs to beneficiaries, and thus the lifetime gifting plan was not implemented.

Everyone’s situation is different and we encourage you to contact us today to look at whether you can reduce your estate’s exposure to the Massachusetts Estate Tax in an income tax sensitive manner.

Knowing the “cost basis” of your property is important for tax purposes, but proving cost basis can be difficult. Cost basis adjusts at death, so it is a good idea to appraise property when a joint owner dies.

Cost basis is the monetary value of an item for tax purposes. When determining whether a capital gains tax is owed on property, the basis is used to determine whether an asset has increased or decreased in value. For example, if you purchase a house for $150,000, that is the cost basis. The cost basis can be increased by improvements to the property. If there are no improvements and you later sell the house for $250,000, you will have to pay taxes on the $100,000 increase in value.  (However, if the property is your principal residence, you can exclude up to $250,000 in gain, or up to $500,000 for a couple.)

When a property owner dies, the cost basis of the property is “stepped up.” This means the current value of the property becomes the basis. For example, suppose you inherit a house that was purchased years ago for $50,000 and it is now worth $250,000. You will receive a step up from the original cost basis from $50,000 to $250,000. If you sell the property right away, you will not owe any capital gains taxes.

When a joint owner dies, half of the value of the property is stepped up. For example, suppose a husband and wife buy property for $200,000, and then the husband dies when the property has a fair market value of $300,000. The new cost basis of the property for the wife will be $250,000 ($100,000 for the wife's original 50 percent interest and $150,000 for the other half passed to her at the husband's death).

The burden is on the property owner to prove cost basis, and it isn't always easy to prove, especially if it has been awhile since the property was purchased or improvements were made. Homeowners should keep good records of improvements to a house, which means keeping receipts and purchase orders. If a joint owner of property dies, you should get the property appraised to show the value at the time it is “stepped up” in basis. Be sure to save the documentation so you can use it later.

For information on cost basis and capital gains on property you inherit, contact us to schedule a meeting.