For the transfer of highly-appreciated assets, such as real estate and stocks, it is rarely wise to give such assets to individuals during life.
Everyone who sees this picture of a cartoon bear sticking a fork in a toaster has the same thought, namely “that is REALLY dumb!” And yet, a surprising number of people have done this very thing at some point in their life. Eventually, most of us do one or more unwise things in our lives. Hopefully, we learn from such mistakes and are smarter after the fact.
This post is something of a repeat of earlier discussions on the ever-recurring example of self-help estate planning, namely the “clever” idea of putting a non-spouse on the deed to a home to “save money” on legal fees and avoid probate. We repeat this discussion because we continue to run into this type of seemingly “clever” planning (but, in reality, very un-clever and unwise) on a regular basis and the results are almost always bad.
This is NOT a novel idea, not by a long shot. It is probably the case that this has been going on for hundreds of years, particularly in the farming communities. However, times and tax laws have changed (we now live in America, rather than the “old country”) and what was once commonly accepted is no longer wise or advantageous from a tax or estate planning perspective. Consider this simple example:
Let’s imagine that my father purchased 5 acres of undeveloped property 50 years ago when he was a young man. This property was pretty much out in the middle of nowhere, so it was also “dirt cheap” (pun intended). He paid $100 an acre, for a total of $500. Then, that land was unused for decades. A few years ago, civilization finally expanded near and around my father’s real estate parcel and now, this piece of land is surrounded by shopping malls, high-rise apartments and lots of other commercial development. In fact, my father’s land is now a veritable gold mine–currently valued at $1,000,000 per acre (for a total of $5,000,000). My father has always been a generous man, and he does not need either this land or the money that would come from selling the land. Therefore, he has determined that he will give this land to me, his favorite child. However, notwithstanding my father’s very kind and praiseworthy motives, if he moves forward with his idea of giving this land to me, the result would be an absolute tax nightmare. Why? Great question, let’s discuss.
Remember that my father originally acquired this land 50 years ago for a total of $500. Today, that land is valued at $5,000,000. If my dad gives me the land, he also gives me his tax basis of $500. Therefore, when I turn around and cash out on this goldmine (2 days after I obtain ownership), selling this land to the highest bidding real estate developer, at first glance, I will be VERY happy to learn that I will be paid $5,000,000 for something that cost me NOTHING. However, my parade will very soon be drenched with heavy rain when I learn from my accountant that I owe a capital gains tax of 20% to 30% on my capital gain of $4,999,500. In other words, I will owe taxes of more than $1,000,000. As outrageous as that is, it is FAR worse to know that just about EVERY PENNY of that tax bill could have been avoided if my father and I had received proper estate planning counsel.
When it comes to transferring highly appreciated assets (such as real estate, stocks, and other investment assets), it is rarely the best course of action to give such assets to persons during life. Rather, if a person is the intended recipient of such assets, you are normally FAR better off to pass such assets through your estate (via a trust or Will) so that there is a “step up in basis” of such assets upon your death. So, let’s see how that could work with the example of my father and his highly appreciated real estate:
By getting a “do-over” and some proper estate planning advice in the process, my father has this time elected to transfer ownership of his property to his revocable living trust and then enter into a long-term lease of his land to several real estate developers. This produces significant rental income in the short term, which is then distributed directly into my pocket on a monthly basis. Then, upon my father’s passing, there is a step-up in basis on this land, since it is included in my father’s estate for tax purposes at his death.
Shortly after my father’s death, I obtain an accredited appraisal of the land, which indicates that the value of the same has then reached $5,200,000. I am then just as greedy as ever, and 2 weeks after receipt of such appraisal, I cash out and sell the land for $5,200,020 to the then-highest bidder. What is my income/capital gains tax bill this time around? Since the land was transferred through my father’s estate, the tax basis of the same was stepped up to the fair market value as of the date of my dad’s death (namely $5,200,020) and so my capital “gain” this time was a mere $20. Even though I would then owe only about 25% of that amount in tax (i.e. $4), I would be feeling particularly generous and decide to give the entire $20–knowing that I had the balance of $5,200,000 or so to enjoy for myself…:)
This rather simple (even if exaggerated) example shows the terrible and VERY expensive tax consequences that can result from gifting highly-appreciated assets during life, as opposed to doing proper and wise planning to transfer such assets through an estate and thereby take advantage of step-up in basis, which, in turn can result in very significant tax savings.
 Contrast this with gifting highly appreciated assets to charity—which may be a very wise move in certain situations.
 As noted above, there are times when it makes a lot of sense to donate highly appreciated assets to charity for tax planning purposes. These would be very specific situations where you have consulted carefully with your accountant, financial advisor, and estate planning attorney. As a general matter, assets which have appreciated in value can, in the right circumstances, be very good candidates for donation to charity as part of an overall tax planning strategy. Donors of such appreciated assets can obtain a tax deduction for the year of gifting. For example, when you donate stock to a qualified charity, you would usually receive a tax deduction for the full fair market value of the stock at the time of donation. This is something which is not understood by many affluent individuals (or even those who are not wealthy) and unfortunately, many charitable organizations are lacking in the resources and expertise to facilitate such transfers/donations which could be highly beneficial to both the donor and the charity.