Critical Decisions in the Timing of Transfer of Wealth

A major consideration in the decision of when is the right time to transfer your wealth is the gift- and estate tax exemption. It is currently at the inflation-adjusted level of $12.06 million per individual ($25.12 million for married couples) but absent Congressional action, it will be half of that amount after 2025. Thus, it may appear sensible to make large gifts now, but there are other factors to consider as well.

Carryover tax basis and stepped-up basis of assets

By making lifetime you remove assets from your estate and shield future appreciation from estate taxes. Your beneficiary receives a “carryover” tax basis — that is, he or she assumes your original or adjusted basis in the asset. The tradeoff is that if a gifted asset has a low basis relative to its fair market value, a sale will trigger capital gains taxes on the difference.

An asset transferred at death, however, receives a “stepped-up basis” equal to its date-of-death fair market value. That means the recipient can sell it with little or no capital gains tax liability. So, the question becomes, which strategy has the lower tax cost: transferring an asset by gift (now) or by bequest (later)?

The answer depends on multiple factors such as the asset’s basis-to-FMV ratio, the likelihood that it will continue to appreciate in value, your current or potential future exposure to gift and estate taxes, and, how long you expect the recipient to hold the asset after receiving it.

If we assume that you and your heirs are subject to tax on capital gains at a rate of 23.8% (the top capital gains rate of 20% plus the 3.8% rate on net investment income) and that the gift and estate tax rate is 40% of amounts in excess of the applicable exemption:

Example #1. You have $8 million in publicly traded securities with a $3 million basis and $2 million in other assets. You haven’t used any of your exemption amount. If you give the securities to your son, who sells them immediately, he’ll owe $1.19 million in capital gains taxes [23.8% × ($8 million – $3 million)]. Suppose, instead, that you hold the securities for life, that the inflation-adjusted exemption in the year you die is $12 million, and that the securities’ value has grown to $13 million. If your son inherits the securities, he’ll receive a stepped-up basis of $13 million and can sell them tax-free. Your estate will be subject to estate taxes of $400,000 [40% × ($13 million – $12 million exemption)]. In this scenario, holding the securities is the better strategy from a tax perspective.

Example #2. Same facts as in the first example, except that your son plans to hold the securities for life rather than sell them. In this scenario, gifting the securities now is the better strategy because, by holding them, your son avoids capital gains taxes and there’s no estate tax because all future appreciation is removed from your estate.

Example #3. Again, the same facts as in the first example, except that when you die the exemption has dropped to $6 million, so your estate is subject to estate taxes of $2.8 million [40% × ($13 million – $6 million exemption)]. In this scenario, gifting the securities now results in a substantially lower tax bill, even if your son sells them immediately.

In the real world, many other factors may affect the overall economics, including an asset’s income-earning potential, the applicability of state income and estate taxes, and potential changes in capital gains and gift and estate tax rates. Contact Agins Law Firm, PLC at (480) 401-2660 for more information.