Sometimes a Gift Can Be a Bad Thing
November 21, 2014 - Posted by: admin - In category:
Everyone likes to receive a gift, right? Likewise, we rightfully praise givers of gifts for their generosity. Even so, in the area of tax planning, giving a gift can sometimes be the wrong thing to do—or at least the giver of such gift should understand that gift tax, capital gains income tax and even estate tax considerations might come into play when gifts are given. The happy news is that with proper planning, such taxes can be greatly reduced, if not entirely eliminated.
Let’s look at a simple example. Assume for a moment that your parents purchased their home 40 years ago for the price of $30,000. Now your parents are at a much different stage of their lives and they are ready to downsize and simplify their lifestyle—they want to move into a small apartment in a senior citizen community. You are the only child, so your parents decide they will simply give you the house right now and you can then decide what to do with the house. You like the idea, since you will then have the option to selling it and pocketing the cash, or you could also turn it into a rental.
Your parents should be commended for their generosity, but two different taxes could come into play if they follow through with their plan to gift you the house. First, there is gift tax. Under federal tax law, a gift in the amount of $14,000 or more (or a gift of real estate or some other asset with a value of more than $14,000) in a single year is a “taxable gift”. In this example, if the current fair market value of the house is $250,000, your parents would be making a taxable gift on the difference between $14,000 and $250,000. This would require your parents to file a “gift tax” return (Form 709) with the IRS when they do their taxes the following year. It is highly likely that your parents would not be required to pay gift tax, assuming they have some portion of their lifetime exclusion amount remaining. Even so, they would have made a taxable gift and they are required to recognize and report the same to the IRS.
Perhaps the more significant tax consideration in this scenario is that of capital gains income tax. Because your parents gifted the house to you, their basis of $30,000 was also gifted to you. The general rule is that a lifetime gift of an asset transfers the basis of the gift-giver in such asset. Therefore, lets then assume that you hold onto the house as a rental for the next 10 years and eventually sell the house for $500,000. In that example, because the house was gifted to you, the tax basis of $30,000 was also gifted to you and therefore you now own capital gains tax on $470,000!! Hmmmm, that doesn’t sound like a good plan. Thankfully, there is a much better alternative for your parents to accomplish their current and future goals and save you a significant amount of money in the process.
Instead of giving the house to you, let’s now assume that your parents received some wise professional counsel and elected to set up a revocable living trust and then transfer ownership of the house into that trust. While the house is in the trust, your parents are free to permit you to use the house as a rental and let’s assume that you go ahead and do this for the next 10 years. Then, 10 years later, when you sell the house for $500,000, your capital gains tax bill will be MUCH lower.
Let’s also assume that your parents’ trust provided that the house remained in the trust, at a minimum, until after the death of both parents and your parents both pass away nine years after they create the trust (which is one year prior to you electing to sell the house). Upon the death of the surviving parent, you are given the option under the trust agreement to obtain ownership of the house and you decide then to exercise this right to transfer the house from your parents’ trust to yourself. At the time of such transfer of the home from the trust to you, the fair market value of the house is $480,000. Given these facts, when you sell the house one year later, you would owe capital gains on only $20,000! Compare and contrast this with the $470,000 capital gains amount that resulted from your parents giving you the house during their lives. Quite a difference, right?
So, you must be thinking that with such a dramatic difference in outcomes, who would EVER choose to go down the path of the gift tax and the exponentially larger capital gains tax bill? Who would choose this? Very few would elect to pay so much more in tax if they knew what they were doing and understood that there was a better way and that better way is 100% legal and proper. The sad thing is that a great many do NOT understand that there is this better way that will save thousands and thousands in unnecessary taxes. This lack of understanding results from people doing their taxes, their accounting and/or their estate planning themselves—thinking that they are going to “save money” in the process. While there are times when “self-help” can save money, far too often, such “self-help” in the context of Life Planning actually COSTS such persons FAR MORE than what they would have paid to get proper help in the first place. Don’t fall into that same trap. You now know better!