Estate Tax, Capital Gains & Gifting
There is a balance that must be struck between capital gains taxes and estate taxes. One of the simplest and cost-effective means of reducing estate taxes at death is gifting while alive. Anyone can move cash out of their estate by gifting up to the IRS annual exclusion amount ($16,000 in 2022) per recipient each year. Additionally, educational and medical expenses paid for the benefit of another are tax free. Such gifts do not count toward the unified Federal Lifetime Gift and Estate Tax Exemption, which is $12.06 million per person in 2022. This means that in addition to the above annual excluded tax-free gifts, anyone can gift up to $12.06 million in assets during life or at death without incurring estate tax.
In New York State, the estate tax exemption is well below the federal exemption amount at $6.1 million. If a resident of New York passes away with assets in excess of 105% of $5.85 million, his or her estate will be taxed on a graduated level up to 16% of the entire corpus, not just the amount over the $6.1 million – which is why it is aptly described as the NYS estate tax “cliff.” This gap between the NYS and federal exemption levels creates the perfect window for gifting during a person’s lifetime. Beware that although New York does not impose a gift tax, any assets gifted within three years of death are clawed back into the estate.
If you are lucky (or savvy) enough to be contemplating making large gifts because your assets exceed $6 million dollars, it is seldom wise or efficient to simply gift such assets outright. Once a gift is made, the donor loses all control, rights and benefits to the gift. Moreover, the worst mistake would be to exchange one tax for another. Certain assets – such as real property and stocks – contain a cost basis, which is the purchase price of the item. If the asset is gifted to another, the done takes the donor’s cost basis in the asset under IRC 1014(a) of the Internal Revenue Code. This is not necessarily bad if the asset has not appreciated in value -the gift recipient is in no worse place than you. But, if the asset is worth more (or less) than the original purchase price – you are missing out on a popular loophole: step up in basis to fair market value at death.
Step up in Basis at Death
Step up in basis at death means that any asset owned at the time of the owner’s death gets a step up in basis to fair market value at death. It would also, negatively, get a step down in basis. As long as the property appreciated in vlaue between date of purchase and date of death, the step up in basis allows beneficiaries of the asset to sell the asset without paying any capital gains tax. Capital gains tax can eat up close to 40% of the proceeds.
Layla bought a brownstone for $500k that is now worth $3 million dollars. If she gifted the property to her children, the recipients would take on the her cost basis of $500k. If the children then sold the property, they would owe capital gains on the $2,500,000 profit. If instead, Layla had left the building her children in a Will or Trust at death, they would inherit with a basis equal to the fair market value of the asset at the time of Layla’s death. If they sold it within 6 months, they would avoid capital gains. If they held onto the property for longer, they only have to pay capital gains tax on the increase between date of sale and date of Layla’s death. This is because their new cost basis is the fair market value at Layla’s death.
Given the drawbacks of outright gifting, there are other estate planning tools available that can provide for tax planning while still retaining control and minimizing capital gains. The family limited partnership is a great transfer vehicle for families to shift tax burdens. Trusts allow the grantor to dictate how, when and to whom distributions are made. Some common trust vehicles are the intentionally defective grantor trust (IDGT), life insurance trust (ILIT), the charitable remainder trust (10% left to charity), and for –married couples—various grantor-retained interest step up trusts and spousal lifetime access trusts.
With any transfer, it is important to consider additional tax implications—including the Kiddie Tax and Generation Skipping Tax (GST)—and complex trust drafting involves input from your financial advisor and estate planning attorney. This is not the sort of planning you do on Legal Zoom.
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