Dear Mr. Miller:
Introduction: I hope you can help. My husband and I have some large real estate holdings in the central valley of California. We want to pass them on to our two adult children. Our net worth is about $4 million. Some people have told me that there is no reason for us to keep our A-B Trust as our children will not have to pay death tax.
I am so confused. Can you explain this and point me in the right direction?
A-B Trusts Explained: A-B Trusts are, indeed, confusing. For those of our readers who are unfamiliar with this device, it is a type of Trust that a husband and wife would create. At its most basic, and without getting into its complexities, upon the first death, conceptually, a meat cleaver is taken to the estate dividing into two halves, the “A” side (or that of the Survivior) and the “B” side (or that of the decedent).
Death Tax Goal: From a death tax standpoint, the goal is to have only the B side be subject to death tax upon the second death. If the B side alone is less than the death tax exemption ($5.49 million in 2017), the estate would pass without death tax. Of course, if the total estate (both sides) is less than the exemption then no tax would exist anyway. At $4 million, that would be your case. However, one must account for appreciation in the real estate. Despite the fact that the death tax exemption tends to increase each year with inflation, California real estate often appreciates faster. So the second of you might die with more than whatever the exemption is at that time.
Portability of Exemption: All of that would argue for an A-B Trust except for the fact that the exemption can be doubled on the first death by a technique called porting (transferring) the deceased spouse’s exemption over to the survivor. So you must come up with an assumption as to whether you believe when you both die you will be above $11 million (roughly twice the present day exemption). If you believe your net worth will be less than that, than the A-B Trust will probably not help for death tax purposes and may even hurt.
A-B Trust Capital Gain Problem: How can it hurt? The B Trust has a negative capital gain feature at the time of the second death. You can read about that here. Although, depending on the circumstances, there may be methods to resolve that problem, why deal with it if you don’t have to?
County Property Tax: So would there be any reason you should use the A-B Trust. Maybe and here we have to get into county property tax. Under California’s famous (or infamous) Prop 13, the children take the same property tax base as the parents and continue to pay county property tax at the parent’s low rate. This is called the parent-child exclusion from reassessment and applies to the parents’ residence and up to $1 million of other real estate.
I’m going to assume that the real estate to which you refer is not your residence. Let’s assume that the $4 million of real estate has an assessed value of $2 million. If 100% is increased for property tax purposes then the new assessed value would be $4 million and at roughly 1%, the new tax would be $40,000. If the children can keep the old assessed value, than the tax would be $20,000, a $20,000 tax savings per year.
Double the Parent-Child Exclusion: So how do the children keep the old assessed value? Without an A-B trust there would be a $1 million exemption (divided between your two children). So the tax assessor would increase the assessed value as to 50% of the property (/$1 million exemption/$2 million old and current assessed value) for a total new assessed value of $3 million (50% x $4 million + 50% x $2 million) for an annual tax of $30,000.
But with an A-B Trust there would be a $2 million exemption (divided between them). The A Trust from the second to die would provide $1 million of exemption and the B Trust from the first to die would provide the other $1 million for a total exemption of $2 million. Since that is the old (and current) assessed value, the $2 million exemption would cover 100% of the property and there would be no increase.