As the holiday season approaches and we get ready for family gatherings, one of the questions that often comes up is whether it is a good idea to gift “assets” to the next generation. The answer is: It Depends.
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Now back to the gifting strategy. Whether or not a gift is tax deductible generally depends on who the recipient is. For example, if you wanted to gift one of your rental properties to your kids, that is not a tax deduction to you. Gifting a property to a family member is generally just a way to transfer an asset from one person to the next. If done correctly, you can transfer the property to future generations without any gift tax issues.
For example, you can have a series of gifts set in place to be able to move a property from your name to your kids’ names without any gift tax issues. In 2014, the annual tax-free gifting amount is $14,000 from one person to another. This means that if both parents are alive and they wanted to transfer a property to their married son, they can potentially gift $56k worth of property this year without any gift tax issues. This is accomplished by:
Mom gifting $14k to son and $14k to daughter in law
Dad gifting $14k to son and $14k to daughter in law
If you had a rental property worth $100k, then you can use this strategy over a two year period to fully transfer this property out of your name and into the name of your kids.
No Tax Deductions for Family Gifts
Keep in mind the act of gifting itself may not be a tax deduction. So if you did gift $56k worth of real estate to your kids, you do not get to write-off $56k worth of real estate. Also, when your son receives this gift, he is not paying taxes on the $56k that he received. In other words, gifting an asset from one family member to the next is not tax deductible to the giftor and not taxable to the recipient.
Gifting Strategies to Save on Taxes
So if you don’t get to write off your gifts to family members then why do it at all? Well, a few reasons. If you have a large net worth, it may make sense to use annual gifting to start shifting assets out of your estate. With estate taxes at a high rate of 40%, it makes sense for a lot of higher net worth individuals to shift assets to the next generation before death.
Another common way that gifting can help save taxes is by shifting income. For example, if you are in a tax bracket that is 15% higher than your kid’s tax bracket, gifting that cash flowing property to your kids can help you to shift the annual taxable income from your high bracket to your family member’s lower tax brackets.
As you can see, although the act of gifting itself may not create a tax deduction, there can be current and future tax savings associated with a properly executed gifting strategy.
When Gifting may be a Terrible Idea
Before you start working on your plan to shift assets to the next generation, make sure you have considered all the facts. Although gifting can provide you with short term and long term tax advantages, it can also end up costing you thousands in unnecessary taxes if not structured properly.
Just like everything else in taxes, a gifting strategy that works great for you may be a terrible for the next investor.
Let’s take an example of dad who did not have large estate in his later years. If dad had simply gifted the property over to his daughter, then the daughter will receive dad’s basis in this property. If we assume that dad purchased this property a long time ago for only $50k and is now worth $200k, gifting means that his daughter now receive dad’s carryover basis of $50k. If the daughter were to sell this property down the road for $200k that means that she has a gain of $150k that she would have to pay capital gains on. This could end up costing her $22k in capital gains taxes.
Alternatively, if this property remained with Dad and he keeps it until he passes away, then when his daughter inherits the property, she gets a “basis step-up” to the fair market value of this property. In this example, if the fair market value of this property at the time of Dad’s death was $200k, then the daughter’s tax basis is now $200k rather than $50k. Using the inheritance strategy, if the daughter decided to turn around one day after inheriting the property and sells it for $200k, she would pay zero taxes on that transaction.
As you can see, the different between dad “gifting” his daughter the property today versus waiting to pass this property to her after his death via inheritance means potential tax savings of $22k.
So what does this mean? Well, simply, that the best answer will depend on your personal situation. If you are looking for ways to make sure you preserve the most amount of wealth for you and your beneficiaries, make sure to work with your advisors to come up with a game plan to do so with the least amount of risk and taxes.