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Lurking in the Weeds: State Death Taxes Make a Major Comeback

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Posted on Sep 30, 2013 | Share this post: Like Us on Facebook Join Us on Google Follow Us on Twitter

Federal estate tax planning impacts far fewer people than it did fifteen years ago. Back then, any individual dying with more than $600,000 could be subject to estate tax.  Revocable Trusts with an “A-B” division became de rigeur for married clients, and single individuals had to think about techniques such as Irrevocable Life Insurance Trusts. Fast forward to 2013, and we have a whopping $5.25 million exemption per person, indexed for inflation. But while this drastically reduces those concerned with the Federal estate tax, many states impose their own separate estate tax, at much lower thresholds.  That can be a nasty surprise for clients and their families.

Arizona currently has no state estate tax. In days long past, states could get a share of the Federal estate tax without increasing the overall tax that people paid. States such as Arizona took advantage of this system, and when the Federal government cut states completely out of the estate tax they collected, they simply lost that revenue.  However, many states were not willing to accept that loss and instituted their own estate tax system, including taxing a lot of estates that are not large enough to incur any Federal tax.

Generally, states can tax someone at death only if that person was a resident of that state or if they owned real estate in that state at the time they died. So, full-time residents of Arizona who own no real property in any other state probably need not be concerned with this issue.  But those who spend significant time in other states and/or own vacation homes, rental property, or farmland in other states should consider how these taxes may impact them and whether there are planning techniques to avoid or reduce the taxes. Additionally, when clients spend a lot of time in two states, they may need to consider which state they want treated as their residence and adjust their time in each state accordingly, along with other typical tests of residency such as voting and driver’s licenses.

When residency is at issue, it may surprise you how intrusive a state’s inquiries can be. On the Massachusetts affidavit, you are asked under oath to answer questions that include: “Did decedent belong to any church, lodge, or other social, fraternal or religious club or organization in Massachusetts? . . . [G]ive name, address, positions held, membership status, etc.”, and “Did the decedent undergo medical treatment or examinations, or was the decedent hospitalized in Massachusetts at any time within five years preceding death? . . . [P]lease furnish names and addresses of the attending physicians and dates admitted or examined.”

As an example of how these taxes work, Minnesota has one of the more aggressive state estate tax systems. The state imposes a tax on any estate in excess of $1,000,000, with a 10% rate over the excess. So, for a Minnesota resident who dies with a $2,000,000 estate, far below even thinking about paying a Federal estate tax, almost $100,000 in estate tax will be payable to the state of Minnesota.

But if a client does not live in that state but simply owns real estate there, even if that real estate is less than the $1,000,000, a Minnesota estate tax will be still imposed proportionate to the value of the estate that’s located in Minnesota. So, if a Tucsonan dies with a $2,000,000 estate, including a $400,000 vacation home in Minnesota, Minnesota calculates the $100,000 total tax indicated above, and then figures since the decedent owned 1/5 of their estate in that state (400,000/2,000,000), that 1/5 of the tax, or $20,000, is payable. It’s not an astronomical amount, but once we get used to the idea of not having to pay estate taxes, that can be an unpleasant check to write.

Before this year, Minnesota did not have a gift tax. Accordingly, one option clients with Minnesota real estate had was to simply give away the property during life. If their total assets were under the Federal $5.25 million exemption, there would be no Federal tax consequences from the gift and they would avoid that. But, as often happens with tax systems, Minnesota realized that was too easy an out and has now instituted its own gift tax as well.

This is just one example of the different approaches states are taking to earn revenue from estates. State taxes vary as much as the states themselves, and they are also constantly changing. If you spend much time in another state or own real estate there, it’s a good time to see if that state has an estate tax and how it may affect you and your beneficiaries.