Take-Away: As you have repeatedly heard from me over the last year, there has been a fundamental shift in estate planning from minimizing federal estate taxes to minimizing federal income taxes. While clients want to continue to make lifetime gifts for a variety of reasons, it is helpful to keep the income tax consequences of lifetime gifts in mind when the client selects assets for lifetime gifts. Sometimes it may be more effective to gift a promissory note to a donee than an appreciated asset.

Background: Since federal estate taxes impact less than 1% of the US population, the planning focus has shifted to reducing a client’s and their heirs’ income tax liability, and capital gains in particular. Several important rules with regard to capital gains taxes apply to gifts:

  • Carry-over Basis: Unlike assets that are received upon the death of the asset owner, where there is a step-up in the income tax basis of the inherited asset, there is a carryover tax basis of the gifted asset from the donor to the donee. If I bought an asset for $100,000 (my basis) which has appreciated during my years of ownership so that the asset’s current value is now $500,000, a gift of that asset by me to a donee means that if the donee turns around and sells the gifted asset, the donee’s income tax basis in the asset will be my old tax basis in the asset ($100,000), exposing the donee to a capital gain tax on the $400,000 gain recognized on the asset’s sale. The combined tax rate imposed on the $400,000 of gain recognition might be around 25% [state 4.25% and federal 20% rates combined] or about $100,000. Maybe the tax burden will be even more if the donee is exposed to the net investment income tax of 3.8% because of their other sources of income causing them to be exposed to the NIIT. Then again, a gift of appreciated assets to a donee who has no other sources of income might result in the donee selling the appreciated asset and not recognizing any capital gain tax.
  • Step-up in Basis: If I hold onto an appreciated asset until my death, that asset will have its tax basis adjusted equal to the asset’s fair market value determined as of the date of my death. Following the same example, if I hold onto the $500,000 asset until my death, and I bequeath that asset to my intended donee-heir, that heir will own the asset worth $500,000 with a $500,000 stepped-up income tax basis. Accordingly, if the heir promptly sells the inherited asset, he/she will pay no capital gains tax. IRC 1014.
  • Loss Assets: Assume I purchased an asset for $500,000 (my basis) but the fair market value of that asset is now $400,000 (a recurring theme with most of my investments it seems.) If that depreciated asset is gifted to the donee that tax loss is $100,000 if the asset is sold by the donee, depending on what happens while the asset is in the donee’s hands. It would be better for me to sell the asset, recognize the tax loss of $100,000,  receive $400,000 (its current fair market value) sales proceeds and give the cash proceeds to the donee. That tax loss can be used to offset my capital gains that I might have recognized on the sale of other appreciated assets during the year, and possibly offset $3,000 of my ordinary income in the year of the asset’s sale that generated the loss.
  • Loss Recognition Rules: Assume that I gift the depreciated asset to the donee ($500,000 price I paid) with a $400,000 current fair market value. If, post-gift, the asset increases in value to more than what I paid for the asset, then the donee will use my income tax basis to determine the capital gain to be recognized when the donee sells the gifted asset. Example: after the gift the asset’s value goes from $400,000 to $550,000 when it is then sold. The donee will use my tax basis, ($500,000) to determine the amount of capital gain the donee must report ($550,000 price received less $500,000 basis = $50,000 gain reported.) If the asset value continues to drop after my gift below the value of the asset at the time of the gift, say down to $350,000, then the donee will use that fair market value ($350,000) to determine the loss to be recognized. If the donee, after the gift, sells the asset for an amount between my original tax basis in the asset ($500,000) and what the asset was worth at the time of the gift ($400,000) then the donee will report neither a gain nor a loss when the asset is sold by the donee. IRC 1015(a).
  • Donee Deathbed Gift Rule: Example: Suppose I am nearing the end of the line (and some days I feel like it!) My daughter purchased an asset year ago for $100,000 and the asset has appreciated while she was the owner, so her asset is now worth $500,000. My daughter is thinking about selling her asset in anticipation of paying college expenses for her son, but she does not want to pay close to $100,000 in capital gains taxes on the sale of her appreciated asset. My daughter (bless her heart!) makes a gift of the $500,000 asset to dear old dad. Dad now owns the asset worth $500,000 but I/he receives a carry-over basis of $100,000 for the gifted asset. We all know that timing in life is everything. I promptly die carrying out my daughter’s ‘plan’, owning the asset worth $500,000 with a basis of $100,000. No big surprise, I bequeath that same asset to my daughter, who intends to claim a basis step-up in the inherited asset to its date-of-dad’s-death value, which she plans to promptly sell and avoid paying any capital gain in order to finance her son’s college education. Not so fast daughter-dear. If I was gifted the asset within one year of my death, and the gifted asset is returned to the donor as an inheritance, then the asset in the hands of the inheritor retains the original income tax basis. IRC 1014(e). This rule prevents a donor from gifting appreciated assets to a second person who is older or in failing health, such that there is a short life expectancy, and who then receives back the same asset due to the donee’s death. If the donee-dad lives longer than a year, then this carryover basis on death rule does not apply, and the income tax basis in the asset is adjusted to its date-of-dad’s-death value. One way to avoid the imposition of this deathbed carryover basis rule is for the person who receives the inherited asset to not be the original donor. Example: If I bequeath the asset gifted to me by my daughter to my daughter’s son, then there is a full step-up in tax basis on my death, even if I did not live a full year after I received the gift from my daughter. Since my daughter may not want her son to receive a $500,000 asset I might choose to beueath a 25% tenant in common interest in the asset to my grandson, with the balance passing to my daughter (with the hope that I survive the gift by at least one year.) But the portion bequeathed to my grandson will receive a full basis step-up, which may then leave him with enough net sales proceeds to pay for his own college education.
  • Implied Understanding Risk: If I received a gift of appreciated assets prior to my death from my daughter, and I bequeath the appreciated asset to my daughter’s son [not my daughter] then IRC 1014(e) should not apply, since my grandson was not the original donor. While that follows the technical rule, the IRS could look at the same facts and attempt to collapse the multi-step transaction arguing that there was an implied understanding that I would bequeath all (or some) of the gifted asset to my grandson which was my daughter’s intent all along, such that my daughter never gave up dominion and control over the gifted asset, even when I (temporarily) held title to the asset, and even though the gifted asset could be seized by my creditors while I was alive, or the same gifted asset could be used to satisfy creditor claims or probate court allowances after my death. The IRS has, on occasion, successfully asserted this implied understanding argument in the past to apply IRC 1014(e). See Private Letter Ruling 9308002. Perhaps if I used the gifted asset as collateral security for a short-term loan after it was gifted to me would provide a strong argument that my daughter gave up dominion and control over the asset after I owned and controlled it.

Conclusion: For older clients who want to make lifetime gifts, but who seem to only own highly appreciated assets available as subjects for those lifetime gifts, it is a tough call whether to use the appreciated assets to complete the gift, due to the carryover basis rule, or to hold onto the appreciated assets until death to exploit the basis step-up on death rule. One fairly easy way to address this dilemma is for the donor to make a gift of a promissory note to the donee, secured by the appreciated asset, instead of using an appreciated asset as the subject of the gift, it continues to be owned by the donor and is used, instead as collateral security for the loan. Upon the donor/promisor’s death the pledged asset will receive an income tax basis step-up to its date-of-death value. The asset can then be sold by the personal representative of the decedent-donor’s estate, without paying any capital gains tax, and use all of the sales proceeds to pay off the promissory note that was given by the donor/promisor during his/her lifetime.