Passing on property to your children or loved ones is a great way to ensure that your legacy lives on. However, if you’re not careful, you could end up paying huge amounts in taxes. The good news is that there are ways you can pass on property without incurring hefty tax bills. Here are some of the techniques that wealthy people use to minimize their tax liabilities while transferring property to their heirs.
Gift tax exclusion
The first technique for passing on property without paying taxes is to use the gift tax exclusion. The annual gift tax exclusion allows you to give up to a certain amount of money or property to another person without incurring gift tax. This reduces the overall value of your estate and can lower the tax burden on your heirs.
As of 2023, the annual gift tax exclusion is $17,000 per recipient (or $34,000 for a couple). This means that you can give up to $17,000 worth of property to each of your children, grandchildren, or other loved ones without having to pay gift tax.
Passing down wealth and giving assets during life may result in hefty federal estate or gift taxes. Those who own properties worth more than $12.92 million for individuals and $25.84 million for married couples could face up to 40% tax rates for 2023.
The current exemption amount is temporary and thresholds will decrease to nearly $6 million and $12 million after 2025 if Congress doesn’t make it permanent. As a result, wealthy families are making gifts to lower their taxable estates before the 2026 deadline.
1031 exchange and step-up basis
Also known as a like-kind exchange, the IRS Section 1031 exchange allows investors to sell their property to buy new without paying capital gains taxes. This deferment allows investors to reinvest their sale profits, including capital gains, into a better-performing property. This means that you can defer taxes for decades by continually exchanging properties.
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In addition, families can take advantage of a step-up basis. This legal provision allows the beneficiaries to receive property at its current market value, rather than the original purchase price. This means that beneficiaries do not have to pay capital gains tax on the appreciation of an asset that occurred during the lifetime of the deceased.
By leveraging these strategies, you can potentially avoid paying taxes during the growth phase, and once the step-up basis comes into effect, your beneficiaries can sell the property without tax obligations.
Trusts
Trusts are one of the most effective ways to minimize estate taxes. A trust is a legal entity that manages assets for the benefit of one or more individuals, called beneficiaries. Trusts can be structured in various ways to minimize the tax liability of your beneficiaries and maximize the assets they receive. Here are common ones the wealthy use.
Grantor retained annuity trusts (GRAT)
This type of trust allows you to transfer your appreciating property to heirs with potentially no estate or gift tax. When setting up a GRAT, the grantor transfers assets into a trust for a set number of years while retaining an income stream in the form of an annuity payment. If the assets in the trust increase in value, any appreciation will also pass to the beneficiaries free of gift and estate tax. The owner or grantor gets back the principal.
Dynasty trusts
A dynasty trust allows you to transfer your wealth to multiple generations without incurring transfer taxes, such as estate and gift taxes. Simply put, any assets you transfer into a trust — including any increase in their value — are only subject to federal gift/estate tax once. From then on, they’re safe from estate taxes and can benefit multiple generations.
Generation-skipping trusts
A generation-skipping trust is a trust that allows you to pass on property to your grandchildren or other beneficiaries who are two or more generations younger than you. This technique can be advantageous because it allows you to avoid estate taxes that would be incurred if you passed on the property to your children first.
Family limited partnerships
A family limited partnership is a type of business entity that allows family members to pool their assets and manage them collectively. By forming a family limited partnership, you can transfer your property to the partnership, which then distributes shares to family members. This move effectively removes your assets from your estate, which in turn results in a reduced estate tax burden.
Life insurance
Even with these tools, it may be difficult to avoid taxes completely. In addition to federal estate taxes, some states also require inheritance taxes. Retirement accounts and real estate property can be challenging to convert into cash. Real estate is illiquid and distributions from a retirement account are considered taxable income.
Life insurance can be an effective way to cover any potential tax payments. By taking out a life insurance policy, you can designate your beneficiaries to receive the proceeds of the policy tax free. Not only can life insurance assist with covering taxes, but it can also provide beneficiaries with additional funds to fulfill other obligations such as paying any mortgages on the property.
For estate planning purposes the wealthy often use cash value life insurance policies. In addition to the income-tax-free death benefit, the cash value can be used for liquidity purposes while you’re alive, and it grows tax-deferred. Getting a life insurance policy helps ensure that beneficiaries won’t have to sell the estate to cover tax obligations.
Passing on property without paying huge amounts in taxes is possible if you know the right techniques. Estate planning can be complicated, so it is important to work with qualified professionals. With the right planning and guidance, you may be able to minimize your tax liabilities and ensure that your legacy lives on.
