The topic of gifting assets is often an important discussion in the world of estate planning. Generally, a main point of gifting is to remove assets from the estate of the donor to avoid potential estate taxes on the asset. Even if a gift is subject to gift tax, gifting early can remove an appreciating asset from the estate at a lower value. However, when considering making a gift, it is important not to forget the potential income tax consequences.
When a donor makes a gift, the tax basis (or the amount from which a capital gain tax is calculated) transfers over to the recipient. This is known as “carry-over basis.” When the recipient later sells the asset, the recipient may have to pay a capital gain tax on the difference between the basis and the sales price.
It may be better to have an asset go through a donor’s estate because the basis of the asset will receive a “step-up in basis” to the fair market value at the time of the donor’s death. The recipient could then sell the asset and pay no capital gain taxes. Given the relatively high estate tax exemptions that now exist it could be that no estate taxes are owed, and capital gains are wiped away due to the basis step-up. Even if Massachusetts estate tax needed to be paid, that estate tax rate is between 8% and 16%, lower than a potential combined federal and Massachusetts capital gains tax rate of 29%.
For example, let’s assume Jane, who lives in Massachusetts, has as an estate of less than $1,000,000 and has made no prior gifts. Jane has stock in Wid Co. that she bought for $10,000, with a current value of $100,000. Jane could gift the stock to her son, who would then have to pay a tax on a $90,000 gain when he sells the stock (because he received Jane’s basis with the gift). Alternatively, Jane could keep the stock and when she passes away leave the stock to her son. If her son then sold the stock for $100,000, he would have no gain to report due to the basis step-up. If we assume that her son’s tax rate on capital gains is 23.8% federal and 5.2% state the step-up in basis reduced his tax bill by approximately $26,000.
As you can see there can be a tax disadvantage to making a lifetime gift. While there can be many instances in which it does make sense to make a lifetime gift, consideration must be given to all aspects of making the gift, including the income tax consequences.