The 4 Questions to Answer Before Making Gifts [Part 3 of 4]

In our estate planning and elder law practice, we talk with many clients who are interested in making significant gifts of assets during their lifetimes to their children. Anytime we meet to discuss lifetime gifting, we inevitably discuss 4 topics of consideration:

1. Will the gift create federal gift tax problems? 2. Will the gift create Medicaid eligibility problems? 3. Will the gift create income tax basis problems for the next generation? 4. Will the gift create state property law problems?

The discussions regarding the first two questions can be found here: Part 1 of 4 and here: Part 2 of 4.  Now, on to the next one:

Will the gift create income tax basis problems for the next generation?

The easiest way to discuss basis is to use a really simple example.  As with anything in the law, it’s rarely this easy, but a simple example will nonetheless provide the illustration necessary to make the point.

Suppose John owns unimproved farmland for which he paid $100,000.00 many years ago.  Suppose further that the farmland is now worth $600,000.00.  John’s basis in the farmland would be his cost ($100,000.00).  If John sold the farmland during his lifetime for an amount equal to the fair market value, he’d have a taxable gain of $500,000.00, i.e., the difference between the fair market value and his basis.

Continuing with our example, consider these two basic principles:

1.  If John still owns the property when he dies, the basis in the property will be “stepped up” to fair market value in his estate for the benefit of the heirs.  In our example, if John died before selling his property, the basis in the hands of the heirs would be $600,000.00.  In other words, the heirs could sell the property for the fair market value and not have to worry about a taxable gain.

2.  If John gives the property away to his children during his lifetime, the children will get “carry over” basis in the property.  In our example, if John gave the property to his children during his life and the children wanted to sell (whether during John’s life or after), the children would have the same taxable gain John would have had, i.e., $500,000.00.

In other words, in our example, if John knew that there was no intent on the part of his children to sell the property, and if there were otherwise good reasons to make the gift, John could go ahead and give the property to his children without having to be concerned with his children unnecessarily incurring income tax in the future.

However, if John knew that his children didn’t want to manage the property and may be interested in selling, and if there was no immediate need to complete the gift, John may put his children in a better position from an income tax perspective if John holds the property until his death so that the property gets a step up in basis, allowing his children to sell the property without incurring a taxable gain.

In short, a gift of appreciated property can sometimes create an unnecessary taxable gain when the receipients of the gift make a sale.

Mark Coriell

Read Part 4

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