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Near-Death Tax Planning Strategies

No doubt you have heard the old adage that nothing in this world is certain except death and taxes. While there is little that can be done to alleviate the pain of losing a loved one, the same is not always true for alleviating the sting of paying income taxes. This brief article will introduce a few ‘near-death’ individual income tax items worthy of consideration: capital loss carryforwards, capital loss harvesting, and charitable contribution carryforwards.

Capital Loss Carryforwards

Capital losses that exceed capital gains are generally limited to an annual maximum loss of $3,000 reported on the tax return. All net capital losses greater than $3,000 are then carried forward indefinitely to future tax years [IRC §1211, §1212]. These carryforward losses will offset future capital gains, but any unused capital loss carryforward attributable to a deceased taxpayer will be lost forever beginning January 1 of the year following death. Thus, it may be beneficial for the near-death account owner to harvest capital gains while alive, in order to use up any capital loss carryforwards.

In other words, if a taxpayer with capital loss carryforwards is experiencing rapidly declining health, they may want to strategically sell appreciated securities.  Similarly, if a married couple has a joint account with a capital loss carryforward, and the spouse dies during the year, the taxpayer has until year end to sell appreciated securities. Doing so will generate capital gains that will be offset by the capital loss carryforwards (which otherwise would be lost at death). Note, the taxpayer may subsequently re-purchase the recently sold securities without negative tax repercussions, essentially receiving a tax-free step up in basis.

Capital Loss Harvesting

As a complement to the first topic, the second item to consider is capital loss harvesting. Many taxpayers hold assets that have decreased in value since they were purchased.  When a taxpayer dies holding such assets, there is no income tax deduction for the unrealized loss – instead, the beneficiary who inherits these assets receives a step down in basis on those assets. Alternatively, if these assets were sold while the taxpayer is alive, the taxpayer recognizes a capital loss that can offset capital gains and can lower the taxpayer’s income tax liability.

The sale needs to be done while the taxpayer is still alive, since the assets are immediately adjusted to fair market value at death. If the assets are not sold prior to death, the potential income tax benefit of the unrealized losses is gone.

Charitable Contribution Carryforwards

Lastly, taxpayers should also consider charitable contributions and contribution carryovers. Charitable contributions are generally deductible in the current year, but large contributions (relative to current year income) are subject to various limitations. For example, the annual charitable deduction for donating long-term capital gain property (i.e. appreciated stock held more than one year) to a qualified charity is 30% of your adjusted gross income. Charitable contributions in excess of these limitations are carried forward up to 5 years [IRC §170]. The risk here again is that if not used up in the year of death, the carryforward is lost in the year following death. Thus, it may be beneficial for a taxpayer to generate additional income in the year of death in order to use up any charitable contribution carryforwards.

In the case of a married couple where the spouse has died, the taxpayer can generate additional income before year end by taking IRA distributions, converting traditional IRA funds to a Roth IRA, and/or harvesting capital gains. The effective tax rate on this additional income could be minimized by the additional charitable deduction it allows. Furthermore, when dealing with carryforwards from donated capital gain property that was originally subject to the 30% AGI limitation, there is a retroactive tax election that can be made to instead deduct the basis of the donated asset (which is subject to a higher 50%-AGI limitation) [Treas. Reg. §1.170A-8(d)(2)]. This election may make sense in cases where the retroactive deduction of basis is greater than the carryforward deduction that is now lost at death.

Consult Your Advisor

If you or someone you know is dealing with the recent loss of a loved one, or has received the devastating news of a life-threatening illness, income taxes may understandably be the furthest thing from your mind.  And while minor, considering the circumstances, having a financial plan to navigate this distressing time can provide a measure of comfort. Each of the above income tax planning items would need to be considered in light of your unique income taxes, estate plan, gifting goals, and financial portfolio.  We recommend prioritizing a conversation with a trusted advisor who is familiar with your comprehensive financial picture to discuss whether these planning items may be pertinent to you.

 

Jason Hass is a Tax Advisor at Wealthquest, a Cincinnati-based financial planning and wealth management firm that offers a full range of financial services under one roof, for one simple fee.

 

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