Understanding the Gift Tax Rules and Why They are Important – Part II

This is the second of two columns discussing the federal gift tax. The first column discussed what constitutes a gift from one individual to another individual, why the federal gift tax was enacted into law, which individuals are affected by the federal gift tax, and what type of gifts are not subject to the federal gift tax.

This column discusses the procedure of an individual’s lifetime giving and how lifetime giving may or may not lower taxes for the heirs of the individual’s estate.

Individuals who have sizeable estates which may be subject to future federal estate taxes when they die may want to minimize or eliminate any potential federal estate tax liability by gifting away some of their estate before they die. Each year, the IRS announces the federal estate tax “exemption” amount. For the year 2023, the federal estate tax exemption amount is $12.92 million per individual, or $25.94 million per married couple. The $12.92 estate tax exemption amount means any individual who dies during 2023 owning a gross estate of less than $12.92 million will not have their estate subject to the federal estate tax.

Some individuals who believe that their estates may be subject to federal estate tax may have been advised to gift in particular their financial assets during their lifetime in order to not have their estate subject to the federal estate tax when they die. Sometimes this gifting is performed when an individual is terminally ill, sometimes called “deathbed” gift transfers. These are gifts of money or property transferred (from the gift donor to the gift donee) before the donor’s death that can reduce the size of the gross estate. Lifetime gifting can be an effective way to transfer money with respect to minimizing any estate settlement costs including inheritance taxes.

However, lifetime gifting can be a complex procedure. The reality is that a “one-size-fits-all” protocol for managing sizeable estates via lifetime gifting does not exist. The fact is that several questions should be asked before individuals with sizeable estates embark on a lifetime gifting program in order to minimize federal estate taxes. Some of the more important questions are presented here.

Will Federal (and/or) State Estate Taxes Be Due?

The first question to ask is: What is the size of an individual’s gross estate? The reason for asking that question is that the federal estate tax applies only to decedent’s estates worth a minimum of $12.92 million ($25.94 million in the case of married couples) during 2023. With that amount of a minimum estate size, the estates of the vast majority of individuals in the US will not be subject to the federal estate tax.

However, state estate and inheritance taxes must also be considered. In 2023, there are 12 states and the District of Columbia that impose state estate taxes on their residents. The 12 states and District of Columbia are listed below in Table 1, together with their estate exclusion amounts:

There are five states that impose inheritance taxes on their residents. These states are listed in Table 2.

For individuals in states with either an estate tax or an inheritance tax (Maryland has both), lifetime gifting may lessen any potential estate tax burden on heirs. Those federal employees and retirees living in one of the states listed in Tables 1 or 2 are advised to consult with a lawyer who specializes in estate/gift tax law before embarking on any gifting action.

But there are a total of 34 states who have neither an estate tax nor an inheritance tax. However, for residents of those states who do not meet the federal estate minimum threshold, lifetime gifting may result in more taxes, not less taxes for heirs as explained below.

When Were the Currently High-Valued Assets Purchased?

The next question related to lifetime gifting relates to “timing;” namely, when were an individual’s assets – in particular, financial assets that are currently high-valued – purchased? When heirs inherit assets, the IRS uses the fair market value of the asset at the time of death as the cost basis for capital gain tax purposes if and when the heirs sell the inherited assets. This is known as a “step-up” in cost basis; namely the cost basis of the inherited asset is stepped-up to the current market value (the value of the asset on the day of the asset owner’s death).
On the other hand, the basis of gifted property is the gift donor’s adjusted basis, plus any gift tax paid on the appreciation of the property to the time of the gift. If assets are gifted to heirs before death, the IRS in most cases will use the original purchase price as the cost basis for capital gain taxes. This is known as the “carry-over” cost basis.

The following example illustrates:

Margaret, a widow, bought her home with her late husband in 1970 for a total of $40,000. The home is now worth $600,000. Margaret in her will bequests the home to her son. If, at the time of Margaret’s death, the fair market value of the home is $700,000 and her son sells the home for $700,000, then her son will have zero taxable capital gain on the sale. This is because the home is subject to the “step-up” in cost basis. The cost basis is determined by the home’s valuation at the time of Margaret’s death.

On the other hand, if Margaret gifts the home to her son before she dies, then her son will take a carry-over cost basis. This carry-over cost basis is subject to the same taxable gain that the decedent (Margaret) would have had; namely a taxable gain of $700,000 less $40,000, or $660,000. This sizeable taxable (capital gain) is a result of over 50 years’ worth of appreciation.

In the majority of situations, it makes financial sense to leave real estate – this includes a principal residence, a second/vacation home or a rental property – in the estate rather than gifting the property before the real estate property owner’s death.

Which Assets Are Not Subject to the “Step-Up” in Cost Basis Rules?

It is important to note that not all financial assets are subject to the “step-up” in cost basis rules. The following assets are subject to the “step-up” in cost basis rules: (1) Real estate; (2) Individual securities including stocks and bonds; (3) Mutual funds; (4) ETFs; (5) Businesses; (6) Art; (7) Furnishings; and (8) Collectibles. The following financial assets are not subject to the “step-up” in cost basis rules: (1) Individual Retirement Arrangements (IRAs) including traditional and Roth IRA; (2) Employer-sponsored retirement plans such as 401(k) or 403(b) plans and the Thrift savings Plan (TSP); and (3) Tax-deferred nonqualified annuities – fixed or variable.

For individuals who live in “community-property” states, there is a potential “double step-up basis.” The nine community property states in the US are: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin. In community property states, all assets and any debts acquired during the marriage are considered joint property and are divided equally between spouses in the event of a divorce. In addition, when one spouse dies and the surviving spouse inherits the property held by the married couple in a revocable living trust, then the “step-up cost basis” is based on the value of those assets held in the revocable trust at the time of the first spouse’s death. This can potentially mitigate a large capital gain if the surviving spouse chooses to sell that asset.

Can a Transfer Via a Gift Be “Undone”?

Most estate attorneys and tax professionals would recommend keeping one’s financial assets in the estate and not making any lifetime gifts. But suppose an individual has already transferred via gift financial assets, especially assets that have appreciated over time such as one’s home that was purchased 30 or more years ago? The question is: Is it too late to do anything about it? Perhaps not.

If an individual is still living in the personal residence that he or she previously gifted to family members, then there may be a way for family members to avoid being subject to a large capital gain tax when the home is sold. If the individual continues to live in the personal residence without paying rent, the individual’s heirs could argue that the parent’s living in the personal residence without paying rent should be interpreted as the individual has a “retained interest” in the personal residence. As such, the personal residence was in fact not gifted from the individual to family members. The personal residence therefore can be pulled back into the individual’s estate.

Take Full Advantage of the Annual Gift Tax Exclusion

In instances in which reducing the size of an individual’s estate makes sense, the annual gift tax exclusion provides a workable “compromise.” During 2023, an individual may give up to $17,000 gift-tax free to as many individuals as he or she wishes. Meanwhile, married couples may give up to $34,00 per recipient during 2023. This gifting removes the money from the estate without incurring any taxes for the recipients.

There is no doubt that managing one’s estate can be a challenge, especially for individuals who live in the 16 states and the District of Columbia which have estate or inheritance taxes. It is therefore important that individuals who are considering a gifting program first seek the advice of a qualified estate attorney and a tax professional in their resident state.