Last week I explained in theory how you can legally avoid paying taxes on gifts and inheritances. Avoiding taxes on gifts and inheritances is based on cost-basis. To help you apply this to your situation I want to share some real-life examples of how my clients use these principles to legally avoid paying taxes on gifts and inheritances.
First, let’s briefly review cost-basis. When you receive an asset as a gift and sell it, you are responsible for paying capital gains tax. Capital gains tax is calculated using cost-basis. Cost-basis refers to how much money was invested in an asset. When an asset is sold, the cost-basis is subtracted from the amount received to determine the gain or loss. Your amount of gain or loss then determines how much you will pay in capital gains tax. In other words, you pay tax on the profit.
Cost-basis becomes complicated when an appreciated asset is passed on to someone else, either through an outright gift or through an estate. If an asset is passed on before the giver’s death, then the recipient assumes the same cost-basis as the giver. If the asset is passed on after the giver’s death, the recipient’s cost-basis is the market value on the date used to calculate tax on the estate. This ‘stepped-up’ cost-basis can save tens of thousands of dollars in capital gains tax.
A reader in St. Maries, Idaho was facing this very situation. A lady has owned some utility stock for decades, happily collecting the dividends. Now she’s getting older and wanted to give this stock to her son. Little did she know this would have resulted in thousands of dollars in unnecessary taxes!
If she had given these shares to her son, he would have a large capital gains tax bill when he sold the shares. The way the IRS sees it, his ‘profit’ wasn’t the gain since he received the gift; his profit was based on how much his mother originally paid for the shares. I explained that if the son inherited that stock after mom’s death, they would legally avoid paying 15% in taxes on decades’ worth of gains. They quickly agreed!
The situation is far different for an elderly client of mine. He lives on a farm that has been in his family for eight generations. He inherited the farm over the 70 years ago and, obviously, it has appreciated greatly. Since his estate will be over $1,500,000, his family could lose up to 50% to estate taxes. Imagine - his daughters could be forced to sell the farm after 8 generations so the tax could be paid!
In this situation, it is better to pay capital gains tax of 15% then estate taxes of 50%. Plus, there isn’t any tax on the gains until the farm is sold. Since his daughters plan on passing it on to their children, the taxes can continue to be deferred for decades. So he’s been carefully gifting the maximum amount he can to his daughters each year over the last ten years. We calculated that he will legally avoid $750,000 in estate taxes.
Few of us have large farms, but most retirees own their home. And many times, the home is the most highly appreciated asset of the entire estate. Unfortunately, as they get older many parents make the mistake of putting their child’s name on the deed to their house. This is an especially common practice for widows.
What people don’t realize is that when they put their child’s name on the deed to their home, the IRS considers that a gift. Therefore, the child has the same cost-basis as the parent. So when the child goes to sell the house later, he or she will face a hefty capital gains tax bill. If the value of the estate is less than $1,500,000, there wouldn’t be any tax on the profit of the house if it was passed through the estate at death.
So think twice before gifting someone an appreciated asset. Remember that adding someone’s name to a bank or brokerage account is the same as a gift. With some simple planning you can legally avoid losing tens of thousands of dollars in taxes.
I’ll personally answer your financial questions. Go to http://www.guardingyourwealth.com and click on ‘Ask Jeff’.
In addition to being a nationally syndicated columnist and Certified Financial Planning Practitioner, Mr. Voudrie provides personal, private money management services to clients nationwide.
Nationally-syndicated financial columnist and Certified Financial Planner® Jeffrey Voudrie provides personal, in-depth money management services and advice to select private clients throughout the USA. He’ll answer your financial question – FREE at http://www.guardingyourwealth.com