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In the first of this two-part series, we noted that gift and estate tax planning is important to a family whenever the net worth of individuals in the older generation is or might become more than $650,000. We also reviewed the fact that although regular gifts eligible for the annual $10,000 exclusion can be the basis of some extremely savvy gift and estate tax planning, there are times that making certain gifts produces unfortunate and unexpected tax results.
This part of the series assumes that you are familiar with the difference in the income tax effects of a transfer of property by gift (during life) and a transfer where the property is part of a taxpayer's estate (at death). If you need an additional copy of Part 1 of this series to review this point, please let me know.
IRA's and PROFIT-SHARING PLAN INTERESTS
These cannot be transferred by gift. The transfer is treated as a taxable distribution to the donor and then a subsequent gift of the amount distributed and taxable to donor to the donee, i.e. recipient.
Tax commentators note new problems due to willy-nilly tax planning for IRA's and Profit-Sharing Plans, even at death. As with installment notes (discussed in Part 1 of this series), the donee will need to continue to recognize the accumulated income inherent in the IRA or Profit-Sharing Plan interest. Also, in addition to the penalty for not withdrawing the required annual minimum distribution from your IRA or Profit-Sharing Plan in a year, and the penalty for withdrawing too much, there is a penalty for simply having too much in your IRA when you die. In the case of a married couple, the test for the last of these taxes can be postponed until the death of the second spouse, but this is still a very tricky area. If you or someone close to you has an IRA whose value is greater than $300,000, particularly if it is a major asset in your or their estate, you should review your income and estate plans regularly with your income tax and estate planning advisors.
PARTNERSHIP INTERESTS--THE NEGATIVE BASIS PROBLEM
ROLE OF DEPRECIATION. As discussed in Part 1, the tax cost or basis of a property starts with the original cost plus the cost of any improvements. When real property is used in a trade or business, including that used for commercial or residential rental (e.g., a shopping center or an apartment house, respectively) a tax deduction is taken each year for a prescribed amount as a measure of the overall "wear-and-tear" on the property. This tax deduction is called depreciation and is based on the type of property (e.g. computer or table or residential rental) and its cost. When such property is sold, its tax basis must be reduced by the sum of the amount of depreciation allowed or allowable in each year.
During the "Go-Go" 1970s and 1980s, it was fairly common for individual taxpayers and partnerships to fully depreciate real property over 16 or 18 years. That is, the sum of the amount of depreciation allowed or allowable over the entire 16 or 18 years equalled the amount of the original purchase price plus immediate improvements. Thus the annual depreciation deductions were significantly in excess of the mortgage loan principal payments, particularly in the first years of the mortgage. After four-six years, it was common for the amount of mortgage or other debt owned on the property to exceed the tax basis (after the effect of depreciation). The property would then be said to have a negative tax basis or negative equity because of the lack of the individual's or partnership's tax equity in the property.
ROLE OF REFINANCING. This situation can also develop for older partnerships, where after the fair market value of the property increased significantly after purchase, the partnership refinanced the property and distributed money to the partners. Since the tax basis of the property is obviously not increased through mere refinancing, if the amount of the loans outstanding after refinancing exceeds the property's tax basis, the partnership will have a negative equity for tax purposes in the property.
RECOGNITION OF GAIN WITHOUT RECEIPT OF CASH. Where an individual disposes of his or her interest in property with negative equity or a partner disposes of his or her interest in a partnership with negative equity (even merely by gift to an object of her or her affection), the relief of the partner for his or her share of the partnership's liability is treated the same as a distribution of cash. Such a deemed receipt of cash, not necessarily accompanied by the actual receipt of cash, at the time of disposition of a partnership interest, even an undivided partial interest in the partnership, may force the partner to recognize gain to the extent of the partner's negative equity in the property. The prospect of recognizing gain or income and paying tax in the absence of the actual receipt of cash is abhorrent to many but not that uncommon in the tax law.
The easiest way out of the negative basis situation is to keep the depreciated property so that the step-up for income tax purposes at death (discussed in Part 1 of this series) will solve the problem. As long as the fair market value of the property is in excess of the mortgage and other debt on the property at the death of the taxpayer, then the negative basis problem will be eliminated.
When the property is held by a partnership, the rules are trickier but it is still possible to eliminate nearly all of the negative basis problem in the partnership context. The one caveat to this is that it will only usually be worthwhile to take the steps to achieve the effects of the step-up of basis in a partnership situation when there is substantial gain, e.g. in excess of $30,000 - $50,000.
PARTNERSHIP INTERESTS--THE PASSIVE LOSS CARRYOVER PROBLEMS
The other problem with real estate rental and other limited partnerships deals with unused passive loss carryforwards. Under current tax law, many taxpayers cannot deduct the losses generated by such real estate rental and nonactive business interests. Supposedly, under current law, you will be able to deduct such unused passive loss carryforwards when you dispose of your interests in the passive activities.
However, dispositions by gift or at death, are not treated the same as sales. If you dispose of your interest by gift, you (the donor) forfeit the passive losses, and the donee benefits by having his or her tax cost or basis in the partnership interest increased by the amount of the unused passive loss carryforwards.
For a disposition at death, the previously unused passive losses can be used on the final return of the decedent to the extent that the fair market value of the property, as listed or as would be listed on the Federal Estate Tax Return, is less than the decedent's tax basis in the property just prior to death. Thus if the property in fact had unrealized appreciation, the unused passive losses are lost at death. Thus if you are using the step-up at death to eliminate the negative basis problem, you will likely lose all unused passive losses in the same maneuver.
REVIEW AND SUMMARY. As I said in the first part of this series, I know this material is fairly difficult to understand. As I also said last time, this is not an area in which you an intuitively figure out what the law is likely to be or make valid assumptions about what the consequences of doing or not doing something are likely to be. If you are involved in any significantly gifting program, or know anyone who is, make sure you or they obtain competent professional guidance.
Copyright Eleanor Hansen 1995
Deductions/Education/Gift&EstatePlans/HomeownershipIncentives/