Do You Owe Taxes On That Gift?

As a Certified Financial Planner, I'm often asked about issues regarding inheritance, gifting and the resulting taxes. Here's a classic example of just how complicated these situations can be, using a question from a reader in Michigan we'll call Bob.

Bob writes: I have a question about my mom's home that I inherited. Before my mom died she put her real estate into joint ownership between her and my sister. It was supposed to help make settling her estate easier. Before mom passed away, my sister died. After my sister died, mom placed the real estate jointly between herself and me. Mom passed away over a year ago and I am now contemplating the sale of her house. After mom's death I had the home transferred to my and my wife's names.

What are my capital gains liabilities on the sale of the house? Do I pay capital gains on the whole sale, half the sale, or none of the sale?

Bob's lack of knowledge is nothing out of the ordinary. Few people are aware of the tax implications and needlessly end up creating a tax headache for themselves and their loved ones.

Let's explain what an inheritance is and how it differs from a gift. An inheritance is money, property, or another asset of value that is transferred after death. A gift occurs when money, property or other assets are transferred before death. An inheritance and a gift are handled very differently from a tax standpoint.

Each of us can give gifts up to $12,000 per year to any person we want without any Federal tax implications. (There may be some state gift tax implications so check with an accountant.)

Inheritances aren't subject to Federal Estate Tax unless the estate's value is over a certain amount, which is currently two million dollars. Because all assets owned by the deceased are included in the estate's valuation (i.e. retirement accounts, annuities, life insurance, etc.), reaching that two million dollar limit is easier than you think.

Even if there is no gift or estate tax when the assets are transferred, there can be capital gain taxes when the assets are sold. The trick is determining the asset's original value, or cost basis, and that depends on whether the asset was a gift or an inheritance.

When you receive a gift, you also receive the cost basis the person giving the gift had. So, if a parent paid $10,000 for a home and it was worth $100,000 when it was gifted to the child, the child now has a cost basis of $10,000. If the house is sold 5 years later for $125,000, the child will owe taxes on a gain of $115,000.

If the house was instead inherited by the child, the cost basis is the value of the house at the time of inheritance, which in our example would be $100,000. So when the house is sold 5 years later for $125,000, the child only owes taxes on the gain of $25,000. In tax parlance, the house received a step-up in basis when transferred after death. It doesn't receive a step-up if transferred prior to death.

Let's apply this to Bob's situation. When Mom added Sister's name to the deed, it was a gift to the sister of 50% of the value of the home and Sister's cost basis was 50% of Mom's cost basis.

When Sister died and the house transferred back to Mom, it was considered an inheritance. So Mom's cost basis on the 50% she inherited was the market value at the time she inherited it back. So 50% of Mom's ownership is based on her original cost basis and the cost basis of the other 50% is the value at Sister's death.

When Mom then adds Bob's name to the property, it's another gift. So Bob will inherit 50% of Mom's new, adjusted cost basis. When Mom dies and the other 50% is transferred to Mr. K, his cost basis in that 50% is the value at the time of Mom's death. Now you know why accountants make all that money!

If Mom had used a Living Trust instead, there would have been no need to add names to her house and her heirs would have 100% of stepped up cost basis, saving thousands of dollars in taxes.

In addition to being a nationally syndicated columnist and Certified Financial Planning Practitioner, Mr. Voudrie provides personal, private money management services to clients nationwide.

Tune Up Your Finances

With the beginning of a new year, it seems everywhere you turn you hear something about self-improvement. There are plans for weight loss, exercise regimens, quitting smoking, going green and more. What about your finances? Even if you think your finances are in ‘good shape’, everyone could use a little ‘tune up’ to make sure everything is running smoothly. And it’s not as hard to do as you think. There are some very simple steps you can take that can make a world of difference.

Step 1: Check your beneficiaries…all of them. A beneficiary is simply who will receive a given asset when you die. Assets with beneficiaries include life insurance policies, retirement accounts and annuities. Even bank and brokerage accounts have a feature called P.O.D. or T.O.D., which stands for payable (or transfer) on death. Many people forget who they listed as beneficiaries, and when they check, are often shocked to find ex-spouses, deceased relatives or estranged family members listed. Do yourself and your loved ones a favor and make sure your beneficiaries reflect your current wishes.

Step 2: Check your Living Trust and/or Will. If you don’t have any plan in place for distributing your assets at your death, by all means put one in place now. If you have a plan, make sure it’s up to date. One of the biggest mistakes those with Living Trusts make is forgetting to keep all their assets in their trust. For instance, have you purchased a vehicle recently, or maybe a vacation home or time share? Made any new investments? If so, be sure they are registered under the name of your trust. Whether you have a Living Trust or a will, be sure there aren’t changes you need to make. Perhaps you have new grandchildren or there has been a divorce in the family. Your designated executor might no longer be the one you desire. Powers of Attorney might not be up to date.

Step 3: Check your insurance needs. Our needs change through life and our insurance needs change along with it. If you’ve recently been blessed with children and/or your once income-earning spouse is now home with the kids, you might need increased income replacement. On the other hand, if you’re newly retired, you might not need as much life insurance as before. You might need more homeowner’s insurance if you’ve built an addition or have valuable belongings. Liability coverage might need to increase. Your auto insurance might have little uninsured motorist coverage.

Step 4: Check your insurance deductibles. By raising your deductibles on your home, car and health insurance, you might be able to save some serious dollars. And don’t be afraid to shop around for better rates. With the internet, getting insurance quotes is easier than ever.

Step 5: Tune up your company retirement plans. Are you putting all you can into your 401(k), 403(b), etc.? Are there any company-matching funds you aren’t benefiting from? You should also review and update your portfolio allocation. Is it all in company stock? (Not a good idea!) Are your funds allocated too conservatively or too aggressively? And don’t forget to check out those beneficiaries while you’re at it.

Step 6: Tune up investment portfolio. The economic climate this year will probably be considerably different than last year. That means that you may need to adjust how your portfolio is allocated. Depending on your needs and your tolerance level you may need to move more money to international or more money out of the markets and into fixed. Asset allocation isn’t something that you want to set and forget.

You may also want to consider who you need to share your financial and estate plans with. For instance, if you are recently widowed and your spouse handled the finances, maybe you want to enlist the help of one of your adult children. If you’ve named someone as your successor trustee or your medical power of attorney, you might want to discuss your desires.

These are by no means the only ways to tune up your finances, but doing even just one of them can make a positive impact. And while our new weight-loss diets might be hard to maintain over time, these financial tune-up steps usually only need to be done once a year.

In addition to being a nationally syndicated columnist and Certified Financial Planning Practitioner, Mr. Voudrie provides personal, private money management services to clients nationwide.

Arbitration Won't Fix It

Some of my best article ideas come from my readers, and this week is no exception. This is a story of misplaced trust, dishonesty, inaction and great financial loss. The lessons learned through their experience will hopefully save you from a similar fate. Read on to find out more.

Bill and his wife, Jane, (not their real names), were a well-educated couple looking to boost their returns. After attending one broker's seminar, Bill was impressed by, his... expertise in company analysis and stop-loss protection.

They decided to put Jane's retirement money into this broker's hands. But after signing the paperwork to open the account, the broker never contacted Jane to find out how she wanted her money managed. Both sides made assumptions about what the other wanted and/or would do.

Jane and Bill were busy, and so was Jane's IRA. We don't know how long it took or how the account did early on, but eventually, over 90% of Jane's retirement money went down the tubes.

The broker promised stop-loss protection but never actually put that strategy in place. The broker determined Jane's risk tolerance without any input from her. When that section of the application was left blank, the broker filled it in it himself so that it, according to Bill, would justify his stock picking and mutual fund selection.

Bill and Jane had to go through arbitration in an attempt to recover their losses, as are almost all brokerage firm clients. After a process that typically takes several years, the panel agreed that the broker had violated 26 NASD regulations. These included lying, the use of erroneous information, total mismanagement of client's accounts and the use of unsuitable investments.

When it was all over, guess who the panel found at fault for Jane's losses?

Jane, of course! They reasoned that since she was a well-educated woman, with a Master's degree no less, that she should have known better than to let it happen. Her husband Bill was even chastised for finding the broker in the first place, and for putting her in a position to lose her money. "We were supposed to know better, not the broker, or his broker-dealer. I am not making this up. My wife got a check for less than 1% of the account value before the losses occurred."

Bill's experience with arbitration is fairly typical. Roughly 50% of arbitration cases are won by the investor, but the award is often a fraction of the damages. Moreover, many times the complaint doesn't even show on the broker's record.

This story has many lessons. Perhaps the most important one is that you bear the primary responsibility for managing your investments. The financial system isn't out to protect the individual investor. Even if you suffer great financial loss, don't expect the system to bail you out.

Bill's story also illustrates the need for investors to have transparent communication with their advisor. If you don't like the investments being used or if you aren't comfortable with the portfolio allocation then let the advisor know.

Don't just assume that your account is doing fine. Watch your monthly statements. Track your portfolio's value. If the value starts to decline significantly and you aren't assured the advisor is taking action to protect it, then find out why. If you don't like the advisor's response, then take your account elsewhere.

Also keep in mind that you won't know if any advisor is right for you until after you've worked with him/her for about a year. If you find yourself laying awake at night worried about your money, though, it's a sure sign that something is wrong.

The bottom line: it's better to prevent significant losses from occurring in the first place instead of trying to recover them through arbitration later. Determine the risk you are willing to assume. If your account value drops to that level then demand that action be taken. You are the boss.

The buck stops with you. You can delegate the day-to-day management and investment selection to a trusted advisor, but it is your responsibility to manage that relationship. Think of yourself as a business owner. If you didn't like the job an employee was doing you'd fire him/her. Take the same approach with your advisor. Remember, it's YOUR money.

I'll personally respond to your questions, free of charge. Go to www.guardingyourwealth.com and click on "Ask Jeff."

In addition to being a nationally syndicated columnist and Certified Financial Planning Practitioner, Mr. Voudrie provides personal, private money management services to clients nationwide.

Building and Maintaining Wealth in 2008

Last year (2007) was a tumultuous year for the stock market. Now that the LED ball in Times-Square has dropped and the confetti has been cleaned up, it's time to briefly recap 2007 and, more importantly, look at how your portfolio should be positioned for 2008.

2007 could easily be referred to as... the Year of the Tums. Our volatile markets experienced three major drops during the year. The first, at the end of February, caused the S&P 500 to fall 4.7% and the emerging markets over 10%. The after celebrating a great first half of the year, the sub-prime fiasco hit in early July and resulted in the S&P 500 losing 7.7% and the emerging markets 17.7%. The year-end rally came early followed by another decline of 7.75% for the S&P 500 and 15.3% for the emerging markets.

In the end, the S&P 500 was up 3.5% and the emerging markets (EEM) were up 33%. Investors, even seasoned investors, have been tempted to throw in the towel and get out of the market. Many have (even institutions have increased their cash holdings). That's why interest rates have fallen so dramatically, with the 10-year Treasury now yielding around 4%.

Let's put this in perspective before you get too depressed! The last time the S&P 500 had a losing year was in 2003. The average annual return on it over the last 5 years has been over 12%. That's well above its long-term average.

The emerging markets (EEM) have done even better. EEM wasn't available for all of 2003, but has been up over 25% each of the last 4 years. To put that in dollar terms, a $100,000 investment in EEM when it came out in 2003 would now be worth around $600,000.

While there is risk associated with investing in the markets, we need to be compensated for taking that risk. Over the last 5 years I would have to say we have. The amount we've earned has far out-weighed the amount we spent on Tums!

Enough about the past. How should you invest in 2008? I can't speak to your situation specifically, but I will tell you about the general themes that I see playing out in 2008 and how you can profit from them. I expect it will be another volatile year so you will have to determine if the potential reward is worth the risk. I believe it is, if you invest correctly.

The U.S. economy is slowing and the housing market/sub-prime crises may continue into 2009. I doubt that we will see returns higher than 10% in the S&P 500. It's more likely that the return could be half of that, but it depends on the Federal Reserve. I expect the Fed to continue to cut interest rates because it must keep our economy from going into a recession, even a mild one.

If you are serious about growing your wealth, you need to invest a portion of your money outside the U.S. markets. The growth in Russia, China, India, and other Asian nations will once again far surpass the growth of our nation, while our inflation is likely to increase. If you don't earn enough, you will actually see your purchasing power decline.

Asian economic growth, combined with even higher mandates for ethanol production in the U.S., will continue to put pressure on commodities like corn, wheat and soybeans. Demand for energy will continue to increase far faster than supply. Oil and coal prices should continue to increase.

This is why I plan to continue focusing on investments outside of the U.S, along with an emphasis on energy, commodities and raw materials. I expect high-dividend paying stocks (such as regional telephone companies) to recover their recent loses. Declining interest rates should drive income-oriented investors back, creating locked-in yields of 8-10% or more.

Investing in foreign companies, energy and raw materials can increase the volatility of a portfolio. You will have to be the judge whether you have the stomach for it. But think about it this way, what are you are trying to accomplish over the next 5 years? The best way to protect your wealth is for it to grow. A drop of 5% or 10% in the short-term pales in comparison to the growth that should be achieved as these major themes play out.

In addition to being a nationally syndicated columnist and Certified Financial Planning Practitioner, Mr. Voudrie provides personal, private money management services to clients nationwide