Considerations in selecting gifts
By Connie Fontaine
The American College
Both gift tax and nontax strategies should be part of an estate owner’s estate planning effort. This requires careful attention to the type of property to gift. With a gifting plan, the selection of assets depends on the donor’s particular goals and circumstances.
There are a number of strategies and factors that must be examined in choosing the types of property that are the most appropriate for a donor to gift. Some general considerations in planning gift tax property are the following:
One general rule of thumb for planners is to select property that will appreciate substantially in value after the time of the gift. Removing the appreciation in the property (as well as the income that may be generated by the gifted property) from the donor’s estate could save a meaningful amount of estate taxes. Meanwhile, the person receiving the gift, the donee, is only too happy to have the appreciation.
These transfers will remove the anticipated future appreciation from the donor’s estate at a time when the property value for gift tax is lower than the later estate tax value. Real estate, certain securities, artwork, collectibles and life insurance are common examples of assets likely to appreciate.
For example, life insurance is an asset with a low present value but has the potential for meaningful appreciation. If the life insurance is held until the date the insured dies, its appreciation in value is guaranteed. Even better, because there are no carryover-basis problems (ignoring 2010 estate tax and basis issues), the proceeds are exempt from income tax.
However, if the death of the donor is imminent, gifts of donor-owned life insurance are not recommended because one Internal Revenue Code section, commonly referred to as the three-year rule, will cause the policy proceeds to be included in the decedent-donor’s estate for tax purposes when a life insurance policy is gifted within three years of death.
Even if the donor’s property has already appreciated by the time the donor considers gifting it, the asset may still be a good choice to transfer. This would be the case, for instance, if gifted property is expected to be sold and the donee is in a lower income tax bracket than the donor.
Income tax brackets
As my last example illustrated, it is important to determine whether the donee is in a lower income tax bracket than the donor. Income splitting between the donor and the donee may be possible if high income producing property is transferred to a family member who is in a lower bracket. Naturally, high-income-producing property is the best choice for this purpose.
Keep in mind that, generally, high-income-producing property should not be gifted to children under the age of 19 (or 24, if a full-time student) because of the “kiddie tax rules.” High-dividend participating preferred stock in a closely held business or stock in a successful S corporation (as long as the stock transfer does not terminate S status) are often good examples of high-income-producing property. On the other hand, if the donor is in a lower bracket than the donee (i.e., a retired parent making a gift to a financially successful adult child), the use of low-yield, growth-type property may be a better selection for gifting.
Planners should determine whether the intended gift of property is subject to indebtedness. A gift of property subject to indebtedness that is greater than its cost to the donor may result in a taxable gain. A gift like this will cause the donor to realize capital gain on the excess of the debt over basis.
Sales and basis
Identify whether the property has a sale price lower than the donor’s basis in the property. If so, the donor should consider selling the property to take advantage of an income tax loss deduction and, perhaps, gift the sale proceeds or select other assets to gift.
Example: The gift of a building that cost the donor $30,000, and was mortgaged to $270,000, appreciates in value to $300,000. This would result in an income tax gain to the donor on the difference between the debt outstanding at the time of the transfer and the donor’s basis (assume $270,000 in debt and the donor’s basis of $30,000). In this example, the gain is $240,000. It is realized at the time the gift becomes complete.
Basis and fair market value
Establish whether the basis of the gift property is above, below or approximately the same as the property’s fair market value. This determination can be important because income tax law denies the recognition of a capital loss if the subject matter of the gift has a basis above the property’s present fair market value. Neither the donor nor the donee can recognize a capital loss with respect to such property.
An additional factor concerning any gratuitous transfer arrangement is that the donor and donee must be mindful of the general rule that the donor’s basis in gifted property carries over to the donee under the carryover-basis rules. Conversely, if the donor’s income tax basis is low relative to the fair market value of the property, the donor might be better off retaining the property until death because of the stepped-up-basis rules for property included in a donor’s gross estate at death.
This can be especially true if including the property in the estate will generate little or no estate tax because it will pass to a surviving spouse and qualify for a marital deduction, or if the owner of the asset is sheltered by the applicable credit amount. The result of the stepped-up-basis provision is that a portion of the donor-deceased’s capital gain with respect to the property is avoided when the property is later sold by the estate or heir. Taking this thought a step further, if the property is likely to be sold by the donee shortly after receipt, it may pay to transfer the gift during the donor’s lifetime to a low-bracket family member as a gift. The recipient could then sell it and realize a lower capital-gains tax.
Ascertain whether the donor is likely to need or want to use the property in the future. If there is a reasonable possibility the donor may want the property, such as a residence, at some later time, other gift property should be selected.
Favorable tax benefits
Determine whether keeping ownership of the property until death would allow a deceased’s estate to qualify for favorable tax benefits under certain Internal Revenue Code sections. To qualify, the value of certain businesses or farm property is required to meet specified percentages of a decedent’s estate.
If a donor is considering making gifts of business interests or closely held stock, the donor needs to consider whether the transfer(s) will disqualify his or her estate from obtaining the favorable tax treatment that is allowed for farms and small businesses under these limited code sections.
There are also numerous nontax subjective issues that donors making sizable gifts should address:
- Determine whether the donor has either expectations or concerns about the donee’s ability to manage or invest the gift.
- Ascertain whether the donor is concerned about equalizing the value or nature of gifts to donees such as children or grandchildren.
- Discover whether the potential for conflict among donees if another donee wants the same gift property.
- Find out whether the donor has concerns about the stability of the donees’ marriages or whether there is the potential for future divorce.
- Determine whether the donor is worried about the donees having creditors’ claims.