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Most individuals have gifted to charity in some form or another during their lifetimes — either for personal reasons or for the possibility of receiving a deduction against their federal income taxes. Alternatively, when it comes to making gifts to their children and grandchildren, many individuals are hesitant to do so for a variety of reasons, including:
- The fear of losing control over those assets gifted
- Feeling that their children or grandchildren are not mature enough to handle gifts made to them
- Not wanting to plan the distribution of those gifts
The following discusses the pitfalls and benefits to be considered before making a gift to a family member, whether it is a gift of cash, appreciated stock or property.
The first step in the gifting process is to understand what is meant by the term “cost basis”. When you make a gift it is important to know what the cost basis of the gifted asset is.
The cost basis of cash is the value of the cash when gifted. To illustrate: if the person making the gift (the “donor”) gifts $15,000 cash to the person receiving the gift (the “donee”), the cost basis of the gift would be $15,000.
The cost basis of stock is what was originally paid for the stock. To illustrate: if the donor paid $1,000 for a stock, which then appreciated to $15,000 before it was gifted to the donee, the cost basis of the gift would $1,000.
The cost basis of property (land, residence, etc.) is the price originally paid for the property, plus improvements. The cost basis would be calculated the same as for a stock, unless improvements were made to the property after it was originally purchased.
Please note that when a donor makes a gift, they make a gift of their original cost basis to the donee. Alternatively, if a donor made a bequest through their Will to a beneficiary, the beneficiary would receive a step-up in cost basis of the asset(s) bequeathed as of the date of death of the donor.
Why is gifting important?
1. Transferring wealth and providing financial assistance
In 2017, the annual gift tax exclusion amount is $14,000 per year per donor ($28,000 for a married couple who are U.S. citizens). In addition, the lifetime individual gift tax exemption amount is $5.49 million in 2017. Donors typically want to maximize the amount of wealth they can transfer under these amounts. What asset a donor gifts usually depends on why they are making the gift and what the gift is being used for.
The difference between making a gift to your child during your lifetime and leaving a bequest to your child at your death is really based on how the transfer tax, if any, would be paid. Gifts are said to be tax-exclusive and Bequests are said to be tax-inclusive. Gifts are considered to be tax-exclusive because of how gifts are made. You do not have to pay tax on the gift before it is made; you just make the gift. For example, if you wanted to make a taxable gift to a child of $100,000 with a tax rate of 40 percent (for simplicity’s sake); you would first make the gift of $100,000 and then you would file a gift tax return and pay the $40,000 gift tax ($100,000 x .40). The cost to you of the gift would be $140,000 = $100,000 (gift) + $40,000 (tax). In effect, the gift tax is exclusive of the gift made.
On the other hand, bequests are considered to be tax-inclusive because of how bequests are made. For your estate to make a bequest to your child it first has to pay taxes on the estate and then it can make the bequest. For example, if you want to make a taxable bequest to a child of $100,000 with a tax rate of 40 percent; you would first have to pay estate tax on the amount of money you would need to have that after being taxed by 40 percent would leave your child with $100,000. The cost to your estate of the bequest would be $166,667 = $100,000 (bequest) + $66,667 (tax = $166,667 x .40). In effect the estate tax is inclusive of the bequest made.
Finally, another benefit of gifting is that all future appreciation that is derived from the completed gift goes to your child’s estate and is not included in your estate. If, instead of gifting, you were to hold the assets until your death and they appreciate in value, the entire value of those assets will be includible in your estate and may be subject to estate taxes.
2. Shift income from high tax bracket of donor to low tax bracket of donee
Gifting assets to a child or grandchild may make sense in the current tax environment if the primary goal of the donor is to shift income. For this strategy to work, it is important that the donee be in a lower tax bracket than the donor.
Assume that a married couple has taxable income (exclusive of qualified dividends and capital gains) exceeding $75,900 in 2017. This puts them in the 15 percent tax bracket for long-term capital gains. Then, assume that the donee has taxable income under $37,950 and they are single. This puts them in the zero percent tax bracket for long-term capital gains. Gifting appreciated assets to individuals in a lower tax bracket reduces the capital gains tax to 1/3 the tax on the married couple.
It is important to note that the donor must be aware of the “kiddie tax”, or rules that limit the amount of unearned income that can be shifted to a child under age 19 and college students under the age of 24. An accountant or tax advisor can help identify ways to reduce the kiddie tax in these instances.
Gifting depreciated capital assets
One other thing to keep in mind when gifting stock or property to family members is that there are rules that apply to gifts of depreciated capital assets:
If the market value of the gift is less than the donor’s cost basis, the donee must use the donor’s cost basis for determining any future capital gains; not the gifted value of the asset.
If the asset is sold by the donee for less than the gifted value, the capital loss is the difference between the gift value and the sales price, not the donor’s cost basis.
If the stock is sold for an amount between the gifted value and the donor’s cost basis, there is neither a gain nor a loss.
Gifting to family members, whether they be children, grandchildren or even siblings involves tough decisions about when, how and in what form to gift. Before making gifts to family members please consult with your attorney, accountant or tax advisor so that the gift is made in the best possible manner to suit your goals and objectives.