How to Maximize the Tax Benefits of Estate Planning Gifts

You need to plan on how to minimize taxes on lifetime gifts, even when the federal estate and gift tax isn’t a factor.

Because of the $11.6 million lifetime federal and gift tax exemption, most people don’t have to worry about owing gift taxes on their lifetime giving. Most people also don’t need to make lifetime gifts to reduce their estate and avoid future estate taxes.

Yet, there are important reasons to make lifetime gifts to children and other loved ones, as we discussed last month. Though under current law you aren’t likely to pay estate and gift taxes, you still should carefully consider taxes in your giving. What’s different now is that income and capital gains taxes should be your focus instead of estate and gift taxes.

The fact is it’s often better to give property instead of cash. Recipients are less likely to spend gifts of property, especially investment property. So, instead of writing a check, consider transferring investment property you own.

But property carries tax characteristics and potential tax bills. The right giving strategies will increase the family’s after-tax wealth by minimizing taxes on property you give and avoiding some tax pitfalls. Here are the key strategies to consider.

• Don’t give investment property that has a loss. Every property has a tax basis, which usually is your cost of acquiring the property. When the property is sold, the gain or loss is the difference between the amount realized and the basis. The higher the basis, the lower the gain (or the bigger the loss).

In most cases, when you make a gift of property, the recipient takes the same tax basis in the property that you had. In other words, the appreciation that occurred during your holding period is taxed when the gift recipient sells the property. There’s an exception when the property declined in value while you held it, making it a loss property.

When you give property with a value less than your tax basis, the beneficiary’s basis will be the lower of your basis and the current market value. Instead of carrying over your basis, the beneficiary must reduce the basis to the current fair market value. The loss incurred while you owned the property won’t be deductible by anyone.

The better strategy is not to make a gift of property that has a tax basis higher than its current value, even if you believe it will rebound for big gains in the future. Instead, sell the property and deduct the loss on your tax return. Then, you have several options.

One option is to make a gift of the after-tax sale proceeds. If you like the long-term prospects, you can recommend the beneficiary use the gift to buy the property. Another option is to make a gift of other property.

Perhaps even better, when you believe the investment is a long-term winner and it is stock or mutual fund shares that can be readily bought and sold, you can buy the property back after waiting more than 30 days (to avoid the wash sale rules that limit loss deductions) and then give it to the beneficiary.

• Give appreciated investment property during a market decline. This is a strategy that makes maximum use of the annual gift tax exclusion and minmizes use of your lifetime estate and gift tax exemption. As we discussed last month, you can give more shares of a stock or mutual fund by making the gift during a price decline that you expect to be temporary. For example, when shares of a mutual fund were at $60, you can give 250 shares tax free under the annual gift tax exclusion of $15,000.

After the price declines to $50, however, you can give 300 shares without exceeding the exclusion limit. When the recipient holds the shares and the price recovers, he or she will have received more long-term wealth tax free. That’s why you shouldn’t focus family gift giving at the end of the year. Determine early in the year the amount you want to give, and then look for a good time during the year to increase the impact of the gift.

• Give property that’s likely to appreciate. A primary goal of lifetime giving is to remove future appreciation from your estate and transfer it to your children or other loved ones. This maximizes your lifetime estate and gift tax exemption and minimizes your lifetime income, capital gains and estate and gift taxes.

Giving property that will appreciate also maximizes the wealth of your loved ones. So, when you have a choice, give your loved ones property you believe will appreciate. This strategy is especially valuable when the beneficiary is in a lower tax bracket than you. When the property eventually is sold, the beneficiary will pay capital gains taxes on the appreciation.

Those gains will be taxed at a lower rate than you would have paid. That’s how you pass on more after-tax wealth and reduce the family’s taxes by carefully selecting the property you gave.

• Hold property that’s already significantly appreciated. Sometimes giving highly appreciated property to a loved one is the smart move. When it’s time to sell the property and the loved one is in the 0% capital gains tax bracket, it’s profitable to make a gift of the property and let him or her sell it. Even if the loved one is in the 10% capital gains tax bracket, the gift can make sense when you’re in a higher capital gains tax bracket.But there are other considerations.

The gain could be significant enough to push the recipient into a higher capital gains tax bracket and a higher overall tax bracket, triggering higher taxes on all the person’s income. More importantly, if there’s not an urgent need to sell the property, remember that you can ensure a 0% capital gains tax on the property by holding it for the rest of your life. You know that when you make a gift of the property, the recipient will take the same tax basis you had in it. The gains that accrued while you held the property will be taxed to the beneficiary at his or her tax rate (unless the recipient is a minor subject to the Kiddie Tax when the gain will be taxed at his or her parents’ top tax rate).

But you could hold the property for the rest of your life so that your loved ones inherit it. When property is inherited, the beneficiaries increase the tax basis to the fair market value on the date the previous owner passed away. The beneficiaries can sell the property right away and owe no capital gains taxes.All the appreciation that occurred during your lifetime escapes capital gains taxes.

From a strictly tax-planning outlook, it’s better to hold investments for the rest of your life that already are big winners and have large capital gains, while making lifetime gifts of other property. You won’t want to do this if the investment fundamentals indicate it is time to sell the asset, but otherwise it’s better to hold the highly appreciated asset and make gifts of other property

.• Give assets that pay income. The odds are you’re in a higher income-tax bracket than the people to whom you’re considering giving property. Consider the different income tax brackets when deciding which assets to give. When you hold investments that generate income each year and you earn more income than is needed to cover your spending, consider giving some of those income-producing assets to others in the family who are in lower income-tax brackets.The move will reduce the income taxes on the income, increasing the family’s after-tax wealth. In addition, the recipient is less likely to sell the assets to raise cash when it’s generating some income each year.

Remember that youngsters age 19 or under (or under 24 if full-time college students) are subject to the Kiddie Tax, imposing their parents’ highest tax rate on investment income they earn above a certain amount, which is $2,100 in 2020. That’s not a problem when the parents’ tax rate is lower than yours. But there aren’t income tax advantages when the income will be taxed at the same rate or a higher rate than yours. I often hear from parents and grandparents who are concerned that leaving their children a lot of money will ruin them.

Annual gifts are a good way to see if that’s true and also to help the following generations get used to handling wealth. Large inheritances usually ruin the heirs when they don’t have the knowledge to manage it or aren’t mentally and emotionally prepared. Sudden wealth tends to cause problems. Lifetime gifts can reduce sudden-wealth syndrome.