Christopher S. Mulvaney,

Attorney and Counselor-at-Law

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THIS WEBSITE INCLUDES GENERAL INFORMATION & THE OPINIONS OF CHRISTOPHER S. MULVANEY. IT IS INTENDED TO STIMULATE A BASIS FOR QUESTIONS RELATED TO YOUR PARTICULAR FACTUAL CIRCUMSTANCES — BEFORE YOU ACT.  THIS WEBSITE DOES NOT CONSTITUTE LEGAL ADVICE. IF YOU WANT LEGAL ADVICE, PLEASE MAKE A ZOOM APPOINTMENT TO SPEAK WITH ME.

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Gonzaga University School of Law – Spokane, Washington – Class of 2002 – Cum Laude The Latin phrase “Deo patriae, scientiis, artibus” translates to “For God and country through sciences and arts”.  The initials A.M.D.G. on the seal of Gonzaga Law School stand for Ad Majorem Dei Gloriam, which is Latin for “For the Greater Glory of God” the Motto of the Society of Jesus (Jesuits): a Catholic religious order founded by St. Ignatius of Loyola.

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If a highly appreciated asset like REAL ESTATE or STOCK held for 50 years or more is transferred to a Beneficiary after the owner of the asset, the grantor, dies, then the Beneficiary receives, under Federal Law, a stepped up cost basis to the fair market value on the date of death of the grantor.

This can be a tremendous tax savings to Beneficiaries. The cost basis of a Beneficiary who receives the same REAL ESTATE or STOCK during the grantor’s is the same cost basis as the grantor.

For example, if a single person is currently affluent enough to have a 20% capital gains rate and purchased REAL ESTATE in Bellevue for $190,500 in 1975, that house would be worth about $5,320,665 in 2025. So, the gain would be $5,130,165 ($5,320,665 Fair Market Value Sale Price – $190,500 Cost Basis).

A 20% tax rate would be $1,026,033 in Federal long term capital gains tax. That is how much the Beneficiary would pay if the Beneficiary received the house during the grantor’s life and sold it. However, if the grantor gives the same house after death, there is a step up in cost basis to the value on the date of the grantor’s death, eliminating the gain and the tax.

However, there is a tradeoff because Washington Estate Tax is owed on everything above the Exemption amount of $3 million.

$5,130,165 Gain – $3,000,000 Exemption = $2,130,165.

The Estate Tax on $2 million is $250,000, plus 17% of $130,165 = $22,128.05 for a Total Estate Tax of $272,128.05.

The logical conclusion would be to pay the Estate Tax because it is $753,904.95 less ($1,026,033 in Federal long term capital gains tax – Total WA Estate Tax of $272,128.05).

THE RESULT IS DIFFERENT FOR APPRECIATED STOCK; THE TAX SAVINGS IS EVEN GREATER.

Instead of REAL ESTATE, if the $5,130,165 long term capital gain was from the sale of Microsoft STOCK, the result would be different because of two additional taxes.

(1) Washington Capital Gains Tax: Washington has a 7% tax on long-term capital gains above a certain exemption ($270,000 in 2024, subject to inflation adjustment). There’s an additional 2.9% tax on gains exceeding $1 million, effective retroactively from January 1, 2025, resulting in a 9.9% rate for larger gains.

So, in addition to the Federal Long Term Capital Gains Tax, there would also be Washington State Capital Gains Tax.

$5,130,165 Gain – $270,000 Exemption = $4,860,165 Net Gain. $1,000,000 x 7% = $70,000. $3,860,165 x 9.9% = $382,156.34.

The Total WA Capital Gains Tax = $452,156.34 on a realised gain from the sale of stock after the Exemption of $270,000 is subtracted of $4,860,165

Gains were over $1 million, so the tax rate increased to 9.9% for the amount above $1 million.

(2) Net Investment Income Tax (NIIT): High-income earners may also be subject to the 3.8% NIIT Federal Tax on investment income, including capital gains.

3.8% Net Investment Income Tax (NIIT) on $5,130,165 = $194,196.27.

The total of the WA Capital Gains and the NIIT is $647,102.61.

• The Net Investment Income Tax (NIIT) is a 3.8% tax that applies to certain net investment income for individuals, estates, and trusts with income above specific thresholds. 
• For Individuals:
• The NIIT applies to the lesser of: 
• Your net investment income.
• The amount by which your modified adjusted gross income (MAGI) exceeds the following thresholds based on your filing status:
  • Married filing jointly or qualifying surviving spouse: $250,000.
  • Married filing separately: $125,000.
  • Single or head of household: $200,000. 
• These thresholds are the same for the 2024 and 2025 tax years. 
• For Estates and Trusts:
• The NIIT applies to the lesser of: 
• The undistributed net investment income.
• The amount by which the adjusted gross income exceeds the dollar amount at which the highest tax bracket begins for the estate or trust for the tax year.
  • For 2024, this threshold is $15,200.
  • For 2025, this threshold is $15,650. 
• Note: Grantor Trusts are exempt from the NIIT. 
• In summary, the NIIT exemption amount depends on your filing status as an individual or the adjusted gross income of an estate or trust. 

So, if capital gains are from STOCK instead of REAL ESTATE, then $647,102.61 in additional taxes (WA capital gains & Federal NIIT) are owed on top of the $1,026,033 for Total Tax of $1,673,135.61.

Comparing the Estate Tax of $272,128.05 on the appreciated STOCK transferred after the grantor’s DEATH, and the Total Tax of $1,673,135.61 on the sale of the appreciated STOCK given during the grantor’s LIFE is a difference in tax of $1,401,007.56.

in this example, the tax savings from transferring highly appreciated STOCK after the DEATH of the grantor is greater than the tax savings from passing highly appreciated REAL ESTATE after the DEATH of the grantor by $647,102.61.

($1,401,007.56 is the difference between the $272,128.05 Estate Tax and State & Federal Capital Gains & NIIT taxes on the sale of the highly appreciated STOCK given during the grantor’s LIFE; $753,904.95 is the difference between the $272,128.05 Estate Tax and the highly appreciated REAL ESTATE given during the grantor’s LIFE.

So, paying the Estate Tax on highly appreciated STOCK is even more worthwhile to do than paying Estate Tax on appreciated REAL ESTATE because of the additional WA State taxes on capital gains and NIIT taxes for STOCK sales.

THE LESSON IS TO HOLD HIGHLY APPRECIATED STOCK AND REAL ESTATE UNTIL YOU DIE; PASS IT TO YOUR HEIRS WITH A STEP UP IN COST BASIS TO YOUR DATE OF DEATH VALUE; AND HAVE YOUR ESTATE PAY THE ESTATE TAX BEFORE DISTRIBUTION TO YOUR HEIRS WHICH MAY RESULT IN HUNDREDS OF THOUSANDS OR EVEN MILLIONS OF DOLLARS IN TAX SAVINGS TO YOUR HEIRS.

ANOTHER OPTION IS TO GIVE HIGHLY APPRECIATED STOCK TO CHARITY TO REDUCE INCOME TAXES DURING YOUR LIFE.

You may be tempted to pass highly appreciated real estate to your heirs encumbered with a Promissory Note and Deed of Trust to reduce the size of your Estate for Estate tax calculation purposes. The legality of signing a promissory note and deed of trust and recording the deed of trust on your home before you die for the express purpose of reducing your estate’s value for Washington State Estate Tax purposes in 2025 is a complex issue with legal and tax considerations that can be accomplished with a Intentionally Defective Grantor Trust (IDGT) or with a Grantor Retained Annuity Trust (GRAT) coupled with a Disclaimer Trust, also called an AB Trust or a Credit Shelter Trust.

While it’s possible to use promissory notes and deeds of trust in estate planning, the key is ensuring the transaction is legitimate and not just a scheme to avoid taxes. 

Here’s why:

• Legitimate Debt: For the promissory note and deed of trust to be considered a legitimate debt against your estate for estate tax purposes, the transaction must be a true and bona fide debt with genuine intent for repayment and all the characteristics of an arms-length loan.
• IRS Scrutiny: Tax authorities, including the IRS and Washington Department of Revenue, are likely to scrutinize transactions that appear to be primarily for tax avoidance purposes. They may challenge the validity of the debt if it lacks substance.
• Estate Tax Deduction: For estate tax purposes, a debt is deductible if it is a bona fide debt against the estate. This means it must be a valid and enforceable obligation of the decedent at the time of death.
• Trusts and Promissory Notes: Some estate planning strategies involve selling assets to a trust in exchange for a promissory note. These strategies can be effective in reducing estate taxes, but they require careful planning and execution.

In Washington State, using a sale to an Intentionally Defective Grantor Trust (IDGT) in exchange for a promissory note is a popular estate planning strategy to reduce estate taxes, especially in 2025 given the potential changes in the federal estate tax exemption. 

How it works:

1. Creation of an IDGT: You create an irrevocable trust that is “defective” for income tax purposes, meaning you, as the grantor, are taxed on the trust’s income. This is intentional, as it helps to reduce your own estate by paying the trust’s income tax, effectively passing more assets to your beneficiaries.
2. Initial Seed Gift: You make an initial gift to the IDGT, typically 10% of the value of the assets you plan to sell to the trust.
3. Sale of Assets to the IDGT: You sell appreciating assets (e.g., real estate, stocks, business interests) to the IDGT in exchange for a promissory note.
4. Promissory Note Repayment: The trust makes payments to you on the promissory note, often structured as interest-only payments or installment payments.
5. Estate Tax Reduction: The key benefit is that the value of the assets sold is “frozen” at the time of the sale for estate tax purposes. The future appreciation of the assets in the trust, which is outside your estate, will pass to the trust beneficiaries free of estate tax. 

Why it’s beneficial in 2025:

• Federal Estate Tax Exemption: The current heightened federal estate tax exemption of $13.99 million per person is scheduled to revert to pre-2018 levels (around $7 million per person) at the end of 2025 unless Congress acts to extend it. The IDGT strategy allows you to “lock in” the higher exemption amount by transferring assets out of your estate before the potential reduction.
• Flexibility: The sale to an IDGT offers flexibility. If the exemption amounts are reduced, you can forgive a portion of the promissory note (up to your remaining exemption amount), converting the sale to a gift and further utilizing the higher exemption. If the exemption is not reduced, the IDGT transaction continues as a valuable strategy for removing appreciation from your estate.
• Income Tax Advantages: As mentioned, the grantor pays the income tax on the trust’s earnings, which helps to further reduce the grantor’s estate and preserve trust assets for the beneficiaries. 

Important Considerations:

• Legitimate Transaction: The sale to the IDGT must be a genuine transaction with a valid promissory note and clear intent for repayment.
• Professional Advice: This is a complex strategy that requires careful planning and execution. It’s crucial to work with an experienced estate planning attorney or tax professional familiar with Washington State laws.
• Intra-Family Loan Rules: You must adhere to the rules governing intra-family loans, including using a market interest rate for the promissory note. 

Other Strategies:

• Grantor Retained Annuity Trust (GRAT): With a GRAT, you transfer assets to a trust and receive an annuity for a set period. Any appreciation exceeding a specified rate passes to beneficiaries tax-free.
• Disclaimer Trust: A disclaimer trust can be used by a surviving spouse to disclaim inherited assets, which can then be transferred to a trust to reduce the surviving spouse’s estate tax liability. 

In Conclusion:

Selling assets to an IDGT in exchange for a promissory note is a powerful estate planning strategy for reducing estate taxes in Washington State, especially in 2025, when the federal estate tax exemption is expected to be reduced. This strategy can help you leverage the current higher exemption amounts and minimize the impact of potential tax law changes. Always seek professional advice to ensure the strategy is implemented correctly and aligns with your specific estate planning goals.

• Washington State Estate Tax: Washington has a state estate tax with a $3 million exemption in 2025. If your estate exceeds this threshold, the portion above the exemption is subject to the tax. Using legitimate strategies to reduce your taxable estate can help minimize your estate tax liability. 

Important Considerations:

• Consult with Professionals: It’s essential to consult with an estate planning attorney or a tax professional familiar with Washington State laws. They can help you determine if this strategy is appropriate for your situation and ensure it is executed legally and effectively.
• Documentation: Maintain detailed records of the promissory note, deed of trust, loan repayments, and all related documentation. This can help demonstrate the legitimacy of the transaction if it is challenged by tax authorities.
• Promissory Note Terms: The promissory note must have commercially reasonable terms, including a market interest rate, repayment schedule, and other typical loan provisions.
• Potential Challenges: The IRS or Washington Department of Revenue may challenge the validity of the debt if there’s evidence it was not a genuine loan with a true intention for repayment. 

In summary, while signing a promissory note and deed of trust and recording the deed of trust on your home to reduce your estate’s value for Washington State Estate Tax purposes in 2025 is potentially legal, it’s crucial to ensure the transaction is legitimate and not a sham to avoid taxes. Working closely with an experienced estate planning attorney or tax professional is essential to ensure compliance with applicable laws and regulations.

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Washington State residents can meet with me in Zoom/DocuSign from anywhere in the world, and I can notarize their electronic signatures because I am a remote online notary.  Just email me an image of your photo ID.