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D. gifts vs. transfers

D. Lifetime gifts vs. transfers at death

Even though the nominal federal gift and estate rates are the same, it takes more money to transfer a given amount, after taxes, upon death than by lifetime gift. The gift tax is calculated like a retail sales tax – just apply the appropriate percentage to the amount of the gift. BUT the federal estate tax is levied on the whole estate “pie.” Tax is paid first on everything – including money that is about to be sent to IRS to pay those very taxes. So the effective rate of the Estate Tax is higher. Thus, lifetime gifts are a more “tax efficient” way to transfer wealth.

BEWARE ! But think twice before making a lifetime gift of any kind of property that has appreciated significantly in value since acquisition.

Prior to the 2001 tax law changes, as a general tax rule, other factors aside, it was better to make present gifts of property that is expected to appreciate significantly in the future, so that the increase in value occurs while somebody else – presumably younger – owns the property. In that way, estate taxation is either avoided, or, at least, delayed for another generation or more. In contrast, it is better to give by Will property that has already gone up significantly in price – like company stock you’ve owned since Day One.

The reason for this difference lies in the arbitrary distinction under the law – at least for now – as to how the donee of the property must compute his/her profit (“capital gain”) for income tax purposes – IF the property is ever sold. The key concept involved is tax “basis,” and it is appropriate to digress here, so that this important term can be considered. “Basis” can be imprecisely, but adequately, explained as follows:

When property is sold, the seller is taxed on any gain – the difference between the sale price received and his tax basis in the property. Generally, your tax basis in property is the amount originally paid for it, plus the cost of any significant additions, upgrades or improvements you made. (Ordinary operating expenses and upkeep are not included in this calculation. If the property is used to produce income, however, these costs are simply deducted each year.) So, the higher the basis you can claim at the time of a property sale, the lower will be the amount of gain subject to income tax.

To keep things simple, let’s consider an asset with a basis – while you own it – that is simply the price you paid. This might be stock in a blue chip company you have owned for many years. But what would be your daughter’s tax basis, if she receives this stock by a lifetime gift, or an inheritance, and pays nothing for it? The answer is not “zero” in either case, but there is a big difference between the gift and inheritance situations. Until the 2001 law changes things after 2009, and even thereafter, to a lesser extent, special rules apply, in which the taxpayer can get a rare and valuable break from the tax code when property is acquired through an inheritance.

Property given by lifetime gift takes the same tax basis in the recipient’s hands as the donor had – generally, the price the donor paid. This is called a “carry-over” basis. But property received by inheritance does not keep the old basis it had in the donor’s hands; it receives a new, “stepped-up” basis for tax purposes. The new basis, which the donee uses to calculate taxable gain if she sells, takes a “step up” to the fair market value of the property on the date of the estate owner’s death. So, if your daughter sells the stock she inherited from you immediately for its fair market value, there will be little or no taxable gain. A lifetime of appreciation in value can totally escape taxation.

This will no longer be true after 2009. Under the 2001 law, the income tax basis of property owned by a person at death will no longer be permitted an unlimited “step up” to its fair market value on the day he died. Instead, a basis step-up of only $1.3 million will be given, with an additional $3.0 million in step-up allowed on property passing to a surviving spouse.

For the time being, however, the following examples are worth understanding:

Example 1: Dad gives Junior 1000 shares of stock in a corporation. (There are no federal tax consequences to Junior unless and until he sells.) Junior sells it the next day at the market price of $60 per share, for a total to him of $60,000. Dad had paid only $50 per share two years ago. What is Junior’s gain? In reality, Junior has “gained” $60,000 he did not have before. But he takes Dad’s basis of $50,000 (the price Dad paid), so Junior’s taxable gain will be only $10,000. ($60,000 – $50,000.) This, of course, would have been Dad’s true profit had he kept the stock himself and sold it.

Example 2: In 1970, using his separate funds, Dad bought 1000 shares of stock in XYZ Co. for $1 per share. His tax basis is simply the price paid. Assume he dies and leaves the stock to Junior in 1995, when it is selling at $75 per share. This becomes Junior’s basis. It has been stepped up, and he will recognize no taxable gain if he sells at that price.

Example 3: (This is a bit more complicated.) In 1970, Mom and Dad bought 1000 shares of stock in XYZ Co. for $30,000, while living in a common law state. They own it jointly, with right of survivorship. Both became terminally ill, and at that time the fair market value of the stock was $280,000. What is the most tax-efficient way of passing the stock to Junior? (Again, there will be no federal tax consequences to Junior upon receiving the property itself; we are talking only about taxation of the proceeds if it is then sold.)

Assume Dad dies first, and soon thereafter, Mom decides to give the stock to Junior on her deathbed. Junior takes the basis in the stock that Mom had, as in Example 1. How do we determine Mom’s basis? It is not $30,000, the purchase price. Remember, as one of two joint tenants, Mom originally owned only half the stock, and her basis for tax purposes was half the price paid – $15,000.

But since then, as a surviving joint tenant, she acquired Dad’s half interest as a result of his death. In this situation, she gets a step up in basis as to that half from Dad. The new basis is fair market value on the date of Dad’s death; the fair market value of half a $280,000 block of stock is $140,000. What about the other half of the block – the one Mom owned from the beginning? No step up on this half. Mom’s basis remains at $15,000 – her half of the original price.

If Junior takes the stock from Mom as a deathbed gift and sells it immediately for $280,000, he also takes Mom’s basis and uses it to calculate his taxable gain. Look at the stock sale one half at a time. For the half that Mom had just acquired from Dad, Junior has a “good” (i.e., high) basis – $140,000. That was the fair market value of this half when it very recently passed to Mom, at the moment of Dad’s death. Assume the price has not moved since, so $140,000 is half Junior’s selling price. Remember that taxable gain is the difference between the sales price ($140,000) and the taxpayer’s basis (also $140,000). Therefore, there is no taxable gain on this half. For the other half of the stock, Junior also receives $140,000, and he again takes Mom’s basis. But this is the half she owned all along. She got no step-up in basis when Dad died. Her basis in this half remains her share (one half) of the $30,000 price Mom and Dad paid years ago, or $15,000. Junior should report a taxable gain of $125,000 ($140,000 – $15,000).

If the stock is bequeathed to Junior in Mom’s Will, however, his basis in the full block of stock is stepped up to fair market value, which we have assumed is $280,000. Therefore, if the stock is then sold by Junior at that price, no gain is recognized, and no income tax need be paid on the $250,000 increase in value.

F.Y.I. There is a potentially important twist to this as it relates to community property: Assume each spouse has a Will that leaves his/her half of all community property to the survivor. When the first spouse dies, the survivor gets the benefit of a step up in basis, not only on the half newly acquired from the decedent, but also on the half he/she already owns. This can result in big tax savings if the property involved has appreciated significantly in value since its purchase. It is a factor favoring community ownership of assets purchased by the married couple, rather than joint ownership, with right of survivorship – in the community property states where there is a choice.

In a common law state, by contrast, whether the surviving spouse gets the decedent’s half by Will, or as a surviving joint tenant, the step up only applies to the newly acquired half of the property – not the half the survivor already owned. Note, however, that this step-up advantage of community property will be eliminated by the 2001 tax law, after 2009.

Obviously, the community property step-up benefit is only available to a couple who have lived – at some point – in a community property state. Yet they need not live there at the time of the first death to receive this benefit. Federal law respects the characterization of property as separate or community made by each state. Most common law states, in turn, respect and retain the community character of property owned by spouses who move there from a community property state.

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