With the increase of the federal estate tax exemption to $5,340,000 in 2014, most taxpayers are not subject to federal estate taxes. The focus for many now has shifted to the income tax implications that arise when wealth passes to the next generation. With no regard to the income tax implications, many times elderly people get the idea that the transfer of real estate to children during their lifetime is a good idea in trying to avoid probate and to make things easier for loved ones. Even uninformed realtors, attorneys and other financial advisers sometime make such a recommendation without knowing the tax impact. However well-meaning, this uninformed strategy can have disastrous income tax results for the children recipients of such ill-conceived lifetime gifts.
It is important to understand the following income tax basis rules for calculating gain or loss:
- Lifetime Gifts: Children who receive lifetime gifts take a carryover basis in the property received. The carryover basis is determined by what the maker of the gift originally paid for the asset plus any improvements made to the property.
- Bequest At Death: Beneficiaries who receive assets at the decedent’s death get a step up in basis to the date of death value of such assets received.
Basis Rules: Illustrating How These Rules Operate
Example: DIY Dad wants to avoid probate and to transfer during his lifetime his real estate to his son, Sad Son. DIY Dad bought his house in the 1970s for $17,000 and made improvements during the years of $23,000. As a result his adjusted basis is $40,000. The house is now worth $540,000. To save lawyer fees, DIY Dad asks Sad Son to draft a deed to transfer the property. Sad Son does so and DIY Dad signs the deed and has it recorded with the recorder of deeds.
- Since this was a lifetime gift, Sad Son takes a carryover basis for the house of $40,000. Sad Son sells the house for $540,000 shortly afterwards and has a capital gain of $500,000 which he surprisingly and shockingly learns from his accountant will cost him $100,000 (20% x $500,000) in federal taxes alone. His accountant tells him there will also be state income taxes on this gain. Since Sad Son is a Pennsylvania resident, he will pay an extra $15,350 in Pennsylvania income taxes. Total Taxes: $115,350.
- Form 709: Any lifetime gifts of over $14,000 require the filing of a Form 709, United States Gift Tax Return, in the year of the gift. It should also be noted the IRS now checks recorded deeds. For more on the IRS policing this area please see IRS Checking Real Estate Transfers For Unreported Gifts.
- Alternate Universe: DIY Dad consults with his tax/estate attorney who drafts a will that provides for the transfer of his house at death to Sad Son. Sad Son (who now legally changes his name to Happy) Son, has a basis of $540,000 upon his receipt of the house from the estate. Happy Son, now sells the house and has zero, yes, zero capital gain (Sale Price $540,000 less basis of $540,000 = 0)!
- Note: Certain states have inheritance taxes. For example, in Pennsylvania there would be a 4.5% inheritance tax on the real estate, but this is a smaller cost than the capital gains tax that results from taking a carryover basis via a lifetime gift.
- Fall Back Solutions:
- If Sad Son stays in the house long enough to qualify the house as his primary residence and all statutory requirements for exclusion are met, he may then exclude $250,000 of the gain on the sale of the house once he sells the house. If married and all statutory requirements are satisfied, Sad Sam may be entitled to a $500,000 exclusion.
- If Sad Son owns the house until he dies, then his children would be entitled to a step-up in basis in the property at his death.
- If Sad Son converts the house to a rental property and then later sells this property as part of a Section 1031 like-kind exchange, gain can be deferred. If he later dies with the swapped property, such property will get a stepped up in basis to the date of death value. This will cut income taxes to the estate or family members who later sell the property.
When Lifetime Gifts Make Sense
It is important to understand that in some situations gift giving may make sense. The following examples come to mind and there may be others depending upon the situation:
- Rapidly Appreciating Assets: If assets will be rapidly appreciating in value in the future, developing a gift giving program may be a better strategy in spite of any loss in step up in basis. It all depends on the particular factual situation presented.
- Taking Advantage of Tax Strategies: In a business context, gifting shares to take advantage of tax breaks associated with the lack of marketability and minority interest discounts may cut estate taxes. For more on these and other gift giving strategies, please read Gift Giving: Tax Advantages.
- Gifts In A Bad Economy or Distressed Industry: Also, in a bad economy or a distressed industry, making gifts may make sense. For a discussion on this topic readers may be interested in Gifting Shares of Stock In A Bad Economy.
This discussion does not explore any Medicaid qualification issues and such considerations should be explored with an elder law attorney specializing in this area.
The key point of this discussion is that making transfers just to avoid probate can result in a tax disaster for your family. Do not do it yourself. Each taxpayer’s particular situation is unique and should be looked at by trained professionals to develop a workable, comprehensive and integrated estate and income tax plan. Get a tax or estates attorney along with your CPA and financial adviser to develop a plan that reduces taxes while still accomplishing your overall financial and estate goals for your family.
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