To Gift or Not to Gift
by Ben Simiskey on Sep 9, 2020
A common question we receive from clients is whether they should gift certain assets to their children or include them in their estate to pass via inheritance. The answer is nuanced and complicated and includes both quantitative and qualitative factors. One significant piece of the puzzle has to do with the tax consequences of each option.
Despite how it sometimes feels, an individual’s income in the United States is subject to income tax only once. The amount you have remaining after income tax has been paid is referred to as capital. And capital is not subject to additional income tax. Gains and losses on invested capital are, however, subject to taxation.
In order to determine the gain or loss on capital, it’s imperative to know the cost basis of the asset. The calculation of cost basis can be surprisingly complex, depending on the situation and factors involved. But for this brief discussion, we’ll stick with the simplistic core of cost basis. At its most basic level, cost basis is the amount originally invested – generally the purchase price plus any commissions or fees involved in that purchase. Adjustments are then made over the life of the asset held.
Basis of Inherited Property
The basis of property that passes through your estate after your death gets a “step up” (or “step down”). The basis is adjusted to the fair market value of the asset on the date of your death. Or, if the executor of your estate chooses, the basis is stepped to the fair market value of the asset on the “alternate valuation date.” That date is six months after the date of death. (Note: For any assets sold by the estate within six months of the date of death, the value will equal the sales price of that asset.)
For many of our clients, this “step-to-fair-market-value” means that assets held for an extended period of time will receive a significant “step up” in basis at the time of the owner’s death. The effect on beneficiaries is that they would generally not owe tax on the capital gain that the owner saw during their holding period.
So, for example, let’s say you own 2,000 shares of a stock you bought 25 years ago for $15/share. That means that your basis would be $30,000 (2,000 shares times $15/share). If the stock is currently trading at $100/share, the value of your holding would be $200,000. So, while you’re living, the amount of gain subject to taxation would be $170,000 ($200,000 fair market value minus $30,000 cost basis).
If you were to pass away today, your beneficiary would receive a step up in basis from the original basis of $30,000 to the current fair market value of $200,000. The result: your beneficiary would have $0 subject to taxation ($200,000 fair market value minus $200,000 cost basis). Any future tax owed would be calculated using the stepped up basis of $200,000.
Basis of Gifted Property
Unlike with an inheritance, if you gift property to another person, your basis in that asset typically transfers to the donee. No gain or loss would be recognized on the day you gift the property, but when the other person sells the asset, tax will be due on any gain (both from the period of time they held it AND the period of time you held it).
In the example above, the person receiving the gifted asset would have the same $30,000 basis that the donor had before making the gift. If that person then sold the asset at the current market value of $200,000, they would owe tax on the $170,000 gain ($200,000 fair market value minus $30,000 cost basis).
This is a very simplified example for illustration purposes only. It should also be noted that there are situations when the asset’s basis for the donee will differ from your basis as the donor – notably, when (1) you pay gift tax on the transfer or (2) when you gift property that has a fair market value less than your basis. In that second situation, you would then get to deal with the double basis rule – twice the “fun!”
Of course, the tax impact of this decision is only one factor. But it can be a critical component in deciding whether to gift assets during your lifetime. For a comprehensive, objective look at all your estate and tax questions and concerns, be sure to work with a fiduciary advisor who focuses on holistic financial planning. We would love to have that conversation with you.