Naturally, this answer is going to be different for everyone, so let me talk about the common mistakes and pitfalls of either bequeathing property at death or gifting while you are alive.
Starting with transfers during your lifetime, one of the biggest issues that we see often surrounds the ultimate income tax consequences with lifetime gifts. Often these gifts are real estate or some other asset that is deemed valuable and appreciating. The income tax issue begins with the basis, or tax cost of the asset in the hands of the donor. The gift recipient, called the donee, has a tax basis for property received by gift that is the same as it was in the hands of the donor. For example, if you are gifted a home worth $500,000 where the donor has a $25,000 tax basis, your built in gain is $475,000. If you later sell the property, you’ll pay taxes on that gain of $475,000.
Because this gift is in excess of the annual gifting limits imposed by the IRS, currently set at $17,000 per donor (as of 2023), you would have to file a gift tax return. You won’t have to pay gift taxes as long as you file a gift tax return and eat into your lifetime exclusion now set at $12.92 million. But in order to do this correctly, you would need to file the gift tax return.
If on the other hand, you passed this property to your heirs upon your death, the property will be eligible for a step up in basis. That means, the new tax cost of the property for the new owners is the fair market value on the date of death. Staying with the facts regarding the property in question, your new tax cost would then be $500,000. Upon selling the property, there would be no gain assuming that you sold it for the current fair market value of $500,000.
While this seems to be a no brainer in term of the ultimate income taxation of the property, you have to ask yourself why you considered making the gift. If it is to help out the next generation, ask if there are any other assets without a tax basis problem that you could gift. Cash is the best as there are no future tax or basis issues with gifts of cash.
If the gift was to protect the asset in the event of a long term health care issue, perhaps paying the income tax from the sale of a low basis asset is better than losing the asset. But ask yourself this, if it came down to a quality care issue for your loved one, what would you rather have? Quality care for the rest of their life which is most likely to be from a private pay level of care or compromise the quality of care so your survivors can eventually benefit from the gift of the real estate?
John P. Napolitano CFP®, CPA, PFS, MST is Founder and Chairman of Napier Financial in Braintree, MA. Visit napierfinancial.com for more information. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Legal counsel should be consulted for specific advice or recommendations about any individual’s personal legal circumstances. Investment and financial planning advice offered through US Financial Advisors and Great Valley Advisor Group, Registered Investment Advisors.