When Gifting Does Not Make Sense: Stepped-Up Basis
One of the commonly misunderstood (or perhaps unknown) issues to be considered with regard to the gifting/transferring of one’s property is the issue of “step-up in basis.” Internal Revenue Code §1014(a) provides that the cost basis of property for the person acquiring same from a decedent is the fair market value (FMV) of the property at the date of the decedent’s death (or FMV within six months of the decedent’s death if such election is made).
Consider the following scenario:
Ruth is an 80-year-old widow, with two adult children. Three years ago, Ruth gifted her home to her children and filed all the appropriate gift tax returns. She made this gift to avoid probate and for Medicaid planning. Ruth purchased the home for $125,000, but it had a fair market value of $950,000 at the time of the gift.
The general rule for gifting is that the gift recipient takes on the gift giver’s cost basis ($125,000 in this case). Assuming neither of the children lived in the home since the time of the gift, they will incur capital gains tax on $825,000 (should the house sells for its FMV of $950,000).
The 2018 long-term investment (property owned more than one year) federal capital gains tax brackets are 0%, 15% or 20% depending on the individual filer’s tax bracket. Without knowing more about Ruth’s children, at a capital gains tax of 15%, her children would owe $123,750 in federal capital gains tax alone. And this does not include any additional state or local taxes owed.
Internal Revenue Code §1014(a) allows for a step-up in basis through making incomplete gifts. Had Ruth sought legal advice, she may have placed the home into a grantor trust, or even transfered the home to her children while retaining a life estate: thus giving the children the property with the basis being its FMV at the time of Ruth’s death and potentially avoiding that $123,750 capital gains tax altogether.
Often people only learn of the issues that arise from the gift, long after the gift is made. A common misconception is that the simple solution would be to return the gift. However, the receiver of a gift has nine months to disclaim the gift, and must not have accepted the interest disclaimed or any of its benefits. In Ruth’s scenario, more than nine months have passed, the children have already accepted the gift, and thus her children are not able to disclaim the gift. As such, any return of the gifts by her children would be considered new gifts to Ruth, requiring her children to file appropriate gift tax returns.
In the above scenario, Ruth gave her children the home with a basis of $125,000. Assuming the children returned the gift and filed the necessary gift tax returns, they will give Ruth back her home with the same basis that she had prior to the transfer ($125,000). While this may sound like a solution to provide her children with a step-up in basis upon Ruth’s death, Ruth must survive the receipt of the gift by one year for her children to receive a step-up in basis upon her death. If Ruth does not survive the receipt of the gift by one year, her children will receive her basis, which is $125,000 for the home.
Making taxable gifts to one’s family without proper legal advice can have detrimental consequences. While the above scenario discusses the gift of a home, similar appreciated property such as stocks, art, jewelry, rare metals, collections, real property, etc. would be subject to a step-up in basis upon one’s death as well. The above scenario points out how Ruth’s children may incur significant capital gains taxes, which could have been avoided with proper planning. Before making a gift of considerable value, it is always recommended that you discuss your intentions with an experienced elder law attorney.