Should You Give Away Your Property? Tax Saving or Tax Disaster?

People often consider giving away property during their lifetimes in order to save taxes without fully understanding the tax ramifications. The topic often arises in discussions about estate planning, particularly last minute estate planning, and in discussions about the sale of assets after death. The concept of a “stepped up” basis is a key factor where the property has appreciated or may appreciate in value. It applies to stocks and other securities, to real estate and to other forms of appreciating property. It provides the potential to save very significant amounts of Federal Income Tax on capital gains if a person retains the appreciated property until death.  

A review of some basic tax principles would be helpful. When a person buys property, such as real estate or shares of stock, the person’s tax basis is generally the cost of the property. If she pays $100 for a share of stock, her tax basis in the stock is $100. If he purchases real estate for a purchase price of $250,000, his tax basis in the property is $250,000. The tax basis of real estate may be adjusted over time - decreased by depreciation and increased by capital improvements. For simplicity, basis adjustments are ignored in this post. 

When a person sells appreciated property, that person has a capital gain or capital loss measured by the difference between the sale price and the tax basis. Assume that share of stock was sold later for $125. The capital gain would be determined as follows: 

Sale Price...................$125

Basis..................…..... 100

Capital Gain...............$ 25

If the owner sold the stock for $125 the day before she died, she would have a $25 capital gain and would owe Federal Income Tax on that $25 gain. Here is where the magic of a basis step up comes into play to alter that result. Federal tax law provides that if a person holds property until she or he dies, the basis of the property is stepped up to its fair market value on the date of death. [FN-1]. This applies whether the property passes to an estate, to a beneficiary under a will, to an intestate heir or to a beneficiary under a trust if the trust is subject to Federal Estate Tax. [FN-2] 

Assume in the example set forth above that the owner of the stock did not sell the stock but instead held it until she died and it was worth $125 on the day she died. Assume further that her entire estate passed to her daughter. If her daughter sold the stock for the same $125 on the day after her mother died, the computation would look like this: 

Sale Price........................$125

Stepped Up Basis............ 125

Capital Gain.....................$ 0

 In contrast, when a lifetime gift of appreciated property is made, there is no basis step up. Instead, there is what the law calls a “carry over” basis. The recipient of the gift receives the same tax basis as the donor of the gift - the basis “carries over.” [FN-3] So again using the example above, if the owner had made a gift of the stock to her daughter while she was alive, the daughter’s basis was the same $100 as the mother’s basis. If she later sold the stock for $125 - whether before or after her mother’s death, the computation looks like this:

 Sale Price...................$125

Carry over Basis.......... 100

Capital Gain.................$ 25

 Where the value of property is expected to or has already appreciated, Federal Income Tax can clearly be saved by holding onto property until death. The down side for Pennsylvania taxpayers is that holding onto property rather than giving it away during lifetime can subject the property to Pennsylvania Inheritance Tax and possibly Federal Estate Tax. [FN-4]. Federal Income Tax is generally going to be between 15% and 20% on the capital gain portion. [FN-5]. Pennsylvania Inheritance Tax is going to be between 4.5% and 15% on the value of the entire property, depending on the relationship between the deceased person and the person who inherits or receives the property at death. Whether it makes more sense to give it away and subject the property to potential Federal Income Tax on the capital gain or hold onto it and subject it to Pennsylvania Inheritance Tax on the entire property depends upon all the facts and circumstances.

 People who are not familiar with the concept of stepped up basis, often have an initial reaction to want to give away the property during lifetime and avoid the taxes imposed at death. While that usually made sense when the threshold for Federal Estate Tax was low because many estates would have been subject to that onerous tax, it no longer makes sense for many estates that will only be subject to Pennsylvania Inheritance Tax at death. Consider the following example: a man owns a town house that he purchased for $200,000 that is now worth $300,000. Ignore any interim basis adjustments. He intends to pass the town house to his son. If he holds onto the property until he dies, the son gets a $300,000 tax basis. If the son then sells the town house for $300,000, he has no capital gain. The cost was Pennsylvania Inheritance Tax of 4.5% on the entire $300,000 value or $13,500 tax.

 If instead, the father had made a lifetime gift of the property to the son, the son would have a carryover basis of $200,000. The son would have saved $13,500 in Inheritance Tax as long as the gift was made at least a year before death. [FN-6]. If the son sold the property for $300,000 and was in the 15% capital gain bracket, the tax on his $100,000 capital gain would be $15,000. If he was in the 20% capital gain bracket, the tax on the capital gain would be $20,000. Saving the $13,500 Pennsylvania Inheritance Tax does not seem like a particularly prudent decision in either event. If the father did not survive for at least a year after the gift, it would be the worst case scenario. Pennsylvania Inheritance Tax would be imposed on $297,000 of the $300,000 value or $13,365 but the son would still owe Federal Income Tax of $15,000 to $20,000 on the capital gain. The capital gain would have been avoided if Federal Estate Tax would have been imposed but it is not avoided simply because Pennsylvania Inheritance Tax is imposed. So the unsuccessful attempt to avoid Pennsylvania Inheritance Tax results in an aggregate tax burden of between $28,365 and $33,365.

 Changing the facts can significantly change what is the better decision. Assume the town house has only appreciated $10,000 so it is worth $210,000. If it is given away during lifetime and sold for $210,000, the capital gain is only $10,000 and the Federal Income Tax is only $1,500 to $2,000 as contrasted with a Pennsylvania Inheritance Tax of $9,450 if it is retained until death. The lifetime gift plan has a clearly better tax result.

 Change the facts in a different way. Instead of leaving the town house to his son, the owner intends to give it to his nephew. In the first example, the Federal Income Tax on the $100,000 capital gain remains the same - $15,000 to $20,000. However, the Pennsylvania Inheritance Tax is imposed on transfers at death to a nephew at 15%. So the Inheritance Tax becomes $45,000 (15% of $300,000). The lifetime gift to the nephew, assuming survival for at least a year, provides a huge tax advantage over holding onto the property.

The moral of the story is that an automatic decision to give away property to avoid Pennsylvania Inheritance Tax on appreciating or appreciated property can often be the wrong decision but depending on the facts, may be the right decision. You simply have to run the numbers on your own particular situation, based upon a full understanding of the tax laws, to determine what is the correct decision. Because of complicating factors like basis adjustments and exclusions for primary residences, the actual computations may be more involved than the simple ones in this post. Like many other decisions in estate planning - and in life generally - basing a decision on half the facts or on a faulty understanding of the law can result in significant unexpected costs. Be careful there is a lot of bad advice out there.

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This post is based upon Pennsylvania law and Federal tax law.

This post is for informational purposes only - it is not legal or tax advice.

Copyright 2019 Marc H. Jaffe

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Footnotes

FN-1 - Internal Revenue Code Section 1014 

FN-2 - Property passing from a trust that is structured to be excluded from the person’s estate escapes Federal Estate Tax but is not eligible for the stepped up basis. 

FN-3 - Internal Revenue Code Section 1015 

FN-4 - If a person’s taxable estate is $11,400,000 or less in year 2019, there is no Federal Estate Tax so for most Pennsylvania taxpayers, the only concern is Pennsylvania Inheritance Tax. That number appears to be going up in year 2020 but is scheduled to be cut in half in year 2026. 

FN-5 - There are special rules for the sale of a primary residence that may exclude part or all of the gain on the sale of a primary residence. A primary residence is still subject to Pennsylvania Inheritance Tax so the decision whether to hold or transfer a primary residence may be different. 

FN-6 - Gifts within a year of death are subject to Pennsylvania Inheritance Tax except for the first $3,000 per year. So if a person gives away $5,000 in April and $10,000 in December and another $15,000 in January and dies in June, Pennsylvania Inheritance Tax is imposed on $7,000 of the December gift ($10,000 - $3,000 = $7,000) and $12,000 of the January gift ($15,000 - $3,000 = $12,000) or on $19,000 in total. The April gift is not subject to this tax because it was 14 months before the date of death - more than a year.