Frequently I hear from people who want to gift away their assets while they’re alive in order “to save taxes” and “make sure the government doesn’t take it all.” Unfortunately though, many of these people are following coffee shop advice from outdated sources or uninformed friends.
The reality is that the majority of people are better off not making gifts during their lifetime and passing assets to their children upon their death. Why, you ask? It's because of what's known as the "Step Up Basis" vs the "Carryover Basis." I'll give you an example.
Suppose Mom and Dad have a 100-acre farm they bought years ago and paid $1,000 per acre or $100,000 ($1,000 x 100 = $100,000). The price paid (less any tax depreciation deductions and other adjustments) is their basis. Ground is not depreciable, so our example is simplified -- the price they paid is their basis. Today, assume that farm is worth $10,000 per acre ($10,000 x 100 = $1,000,000). This is referred to as the “fair market value”.
Mom and Dad are not relying on the income from the farm and they’re thinking about gifting it to their children.
From a tax perspective, they'd be much better off leaving it to their children through their estate, rather than gifting it while they are alive. That's because gifts have a carryover basis. Even though gift tax is calculated based on the fair market value of the asset being gifted, the person receiving the gift will have the same basis as the person who made the gift.
To continue with the example, assume Mom and Dad go ahead and gift the farm to their children. Assume they’re savvy, and gift it over a number of years by using their annual exemption amount ($15,000 per year beginning in 2018). Great. The kids keep the farm while Mom and Dad are alive, and after Mom and Dad pass away they want to sell the farm.
They sell it for the $10,000 per acre fair market value ($1,000,000 total), but what happens? Remember, their basis in the farm was $100,000, so their gain is $900,000 ($1,000,000 sale price minus $100,000 basis). They have federal capital gains tax and state and local income tax to pay. So, they’ll pay about 25% of the gain, or $225,000, in taxes on that sale.
Now assume that Mom and Dad waited until they passed away and left the same farm to the kids on their death (it doesn’t matter whether they leave it through their Will or a living trust). Because it passed through Mom and Dad’s estate, the kids receive a step up in basis to the fair market value at the time of Mom and Dad’s death. So, the farm is worth $10,000 per acre at the time of their death and the kids sell it shortly thereafter for the same price. Now what happens? The kids don’t have any gain on the sale because their basis equaled the sale price. So, on the $1,000,000 sale, there are no federal, state, or local taxes to be paid. The family “saved” $225,000 in taxes by not making gifts.
This simple example illustrates the significant income tax consequences associated with planning decisions. Gifts are still an ideal planning tool for large estates with exposure to federal estate taxes, and sometimes people just want to make gifts so they can see their children enjoy them.
If you’re thinking about making gifts and want to make sure you’re considering the impact on your overall estate plan, as well as selecting the most appropriate assets to gift, please reach out and we will be happy to review your specific situation in detail. You can always contact us via our website (http://gutweinlaw.com/contact-us), or give us a call at 765. 423.7900.
Here’s to seeing what's next!