Can’t I Just Give It Away?

Part 2: Consequences of Gifts

Throughout our lives, many of us desire to divest part of our estate to others.  There are a variety of reasons for doing so, including tax avoidance, protection against long term care costs, charitable inclination, and the mere desire to make family members and friends happy.  However, there are often certain perils in giving away assets, including capital gains taxes, income taxes from deferred assets, gift taxes, loss of government benefits, and economic issues facing a gift recipient.  A complicating factor in making gifts is that the laws affecting gifting and government benefits are inconsistent.  Thus, one must obtain prudent advice before making significant gifts.

In the first part of this article, the various types of gifts were discussed.  This section shall focus on the consequences of making these gifts.  Certain gifts are better to make than others.  Some contemplated gifts probably should not be made at all.

One must recognize there are potential income tax issues with gifting.  Without a doubt, gifts of certain assets carry virtually no income tax ramifications.  Such gifts include cash and ownership interests in checking accounts, saving accounts, money market accounts and mutual funds.  Certificates of deposit do not either; however, they may be subject to a penalty for early withdrawal if cashed prior to the maturity date.

Most asset transfers are subject to either capital gains or gift tax ramifications.  If real estate is transferred during lifetime, it is subject to carryover basis.  For example, Mom bought a house for $30,000 thirty years ago.  She puts another $30,000 of capital improvements into the home over the years.  Thus, her basis is $60,000.00.  She transfers the home to her children during her lifetime.  Her basis of $60,000 is carried over to them.  Thus, if they sell the house in the future for $350,000 – regardless of whether Mom is alive or dead – they will incur a capital gain of $290,000.  Tax on that capital gain will need to be claimed and paid on their next set of 1040s.  If Mom instead leaves the house in her Will to her children, they will receive what is known as a step up in basis upon her death.   That is, when one dies, the basis in their capital assets is stepped up from their original value or basis to the value at the individual’s date of death.

As to real property, there is an exception to this rule.  Specifically, Mom can retain a life estate in her house.  If she does, the basis will be stepped up when she dies.  However, if Mom was gifting the house to minimize estate taxes, this retention will cause the property to be brought back into her estate when she dies and, thus, be subject to the taxes she wanted her estate to avoid.  Of course, if Mom is not concerned with estate taxes, this may be a sound alternative.  In doing so, Mom needs to ensure that the deed of conveyance is drafted in a manner which allows her to retain any tax advantages to which she may be entitled including property tax deductions for being a senior citizen and/or veteran as well as any homestead or other state-funded rebate.

Other capital assets follow similar rules.  Although there are some relatively rare exceptions, most do not allow for the retention of a life estate.  Thus, transfers of stock or business interests typically work under the rules for carry over basis and step up in basis mentioned earlier.  For example, if Dad purchased stocks for $50,000 many years ago, that is the basis of these stocks.  If he gives these stocks away during his lifetime, the basis gets carried over to his children.  If they are received by his children upon his death, the basis will be stepped up.

It should be noted that the capital gains tax, if any, is not due until the stock, real property, or other capital assets are sold by a donee.  This applies regardless of whether the assets are transferred by the donor during lifetime or by this estate after he or she is dead.  Of course, if such assets are liquidated to make cash gifts during the donor’s lifetime, the donor has to pay any capital gains for the year in which the liquidation(s) occurred.

Tax deferred assets carry immediate consequences.  These assets include retirement plans, IRAs, and annuities.  With rare exception, if these assets are transferred, the IRS and state treat the event as if it is a complete withdrawal.   Thus, the donor has to pay the tax on all of the deferred income in the year the transfer occurs.

Overall, one can see that transferring assets may be more complicated than it appears on its face.  Thus, it is prudent for individuals to seek competent professional advice before embarking on any significant gifting program.

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