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LOOKING A GIFT HORSE IN THE MOUTH (PART 1 OF 2)
It is said that it is better to give than to receive, but seriously, who should give? We are not talking about gifts to charity but to family and significant others. Should you or your family care about a gifting plan and gift and estate tax? You or your family should if the net worth of the individuals in the older generation is or might become more than $650,000. It is roughly in this net worth range that estate and gift tax planning becomes useful in terms of producing greater savings than it costs.
As I have discussed before, the cheapest way to honestly and
reliably reduce your or your family's estate and gift tax is to
take advantage of the $10,000 that each of you (a donor) can give
annually to each object of your affection (recipient or donee)
free of estate or gift taxes. In the long run, this can save possibly
tens or even hundreds of thousands of dollars in gift and estate
tax.
The major point of this article is to explain why some property
is better retained by the donor and not given away. As I noted
above, it is said that it is better to give than to receive, but
as you will see, some gifts are better than others.
INCOME TAX SAVINGS NEED TO BE KEPT IN MIND. In our quest to reduce or even eliminate estate and gift tax, we do not want to increase the income tax of those involved so much as to offset the proposed tax savings. One reason income tax is involved is because sooner or later we usually sell the property we are given or inherit. When we sell this property, we realize gain or loss. The gain on the sale of property that we have purchased is the sales price (SP) minus the original cost plus the cost of any improvements (TB) and any expenses of sale (SC), eg. G = SP - (TB + SC).
The original cost plus the cost of any improvements is the tax cost or basis (TB) of the property. The acquisition tax basis or tax cost of most property acquired from a decedent, e.g. at a person's death, either through a will or by trust instrument, is its fair market value at date of death. Thus, if the property acquired by inheritance increased in value during a decedent's life, it is said to have a step-up in its tax cost or basis at his or her death. In contrast, the acquisition tax basis or tax cost of most property acquired by gift is the lesser of the donor's original acquisition cost or its fair market value at the date of the gift.
This increase or step-up in value at time of death has the effect of eliminating any or most gain on subsequent sale of property acquired by inheritance. For instance, if your mother and father purchased their home in 1952 for $20,000 and your mother died last year (and your father had died earlier, leaving the home to her), at which time the residence had a value of $240,000. You expect to sell the property this year for $250,000 less the usual sales commissions and closing costs. Since your tax cost or basis will be $240,000, instead of having $230,000 or more of gain, you will have a loss for tax purposes. This is because your gain (G) would be the excess of the sales price of $250,000 (SP) over your basis of $240,000 (TB) plus the sales costs of $15,000 to $16,000 (SC), eg. G = SP - (TB + SC).
In contrast, if the same property had been transferred before
death by gift, the gain would be of the order of $230,000. Thus
the difference between making a gift or a transfer at death could
be $70,000 to $80,000 of income tax.
Although gift and estate tax rates are commonly on the order of
43%-50%, combined Federal and California income tax rates are
of this order of magnitude also, so that much of what tax planners
do is help clients avoid both kinds of taxes to the greatest extent
possible, and not let clients avoid gift and estate tax at the
cost of increased income tax.
There are exceptions to the rule that property acquired from a decedent has its value adjusted at date of death. The most commonly seen property types that do not receive such an adjustment in value are I.R.A.'s, profit-sharing and pension plan interests, and installment notes from the sale of property. In all these cases, the income that needed to be recognized by the decedent as of date of death will need to be recognized by his or her heirs.
HIGH BASIS, LOW VALUE PROPERTY. In general is it a good idea to make a gift of property that you think will appreciate in value in the future so that the expected post-gift appreciation will be transferred to the donee without incurring gift or estate tax. The exception to this is property that has significantly decreased in value since it was acquired by the donor. In this situation, the donor should consider just selling the property, and taking the tax loss, to offset capital gains or up to $3,000 a year of other income. There are fairly complicated rules as to what a donee's basis is in a situation such as this, but the bottom line is that the potential tax loss cannot be shifted to a recipient. In the case of a gift in this situation, the tax advantages of the potential loss evaporate at the time of the gift.
INSTALLMENT NOTES. Just as you cannot transfer the loss in the above-described situation, you cannot transfer the gain in an installment note by a pre-death gift transfer of the note. The gain inherent in an installment note can only be transferred in what is called a qualified disposition. Testamentary transfers, that is, transfers at death, either through a will or a trust, are qualified dispositions. Thus if the installment note is retained by the donor and given to a donee at the donor's death, that is fine. Note that the recipient generally will still need to continue to recognize the gain that the deceased donor was recognizing.
According to tax law, the opposite result is seen if the installment note is transferred by gift. A transfer by gift is not a qualified disposition, so the transfer by gift triggers the recognition of all the remaining gain by the donor. This surprisingly unhappy result is quite clearly spelled out in IRC sec 453B of the Internal Revenue Code.
If you desire to have an object of your affection share in the gain in an installment sale, you will need to make a gift or a series of gifts of the underlying property. Thus, long-term planning will clearly pay off where installment notes are likely to be involved. If the property is of sufficient value, and issues of control and management sufficiently complex, the use of a family limited partnership should be considered.
PREVIEW. In the second part of this article we will discuss some tricky tax planning aspects of working with IRA's and with tax-shelter partnership interests.
REVIEW AND SUMMARY. For many of you, I know this material is fairly difficult to grasp and plow-through. In summary, I would like just to say that this is not an area in which you can intuitively figure out what the law is likely to be or make valid assumptions about what the consequences of doing or not doing something are. If you are involved in any significantly gifting program, or know anyone who is, make sure you or they obtain competent professional guidance.
Copyright Eleanor S. Hansen, 1995
Deductions/Education/Gift&EstatePlans/HomeownershipIncentives/