Gifting, Inheritance, and Capital Gains Tax: When Should I Give My Kids Their Inheritance?

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January 9, 2024

As people begin to think about passing on their assets to the next generation, some consider gifting to their children during their life, rather than passing their assets by inheritance at their death.  Possible motivations for this type of transfer include transferring ownership of a business to a child or the protection of assets in the event nursing home care is needed.  However, the potential advantages of lifetime gifting should be weighed against the often significant tax advantages of basis adjustment for transfers made at a person’s death.

Basis is a tax accounting measure of the cost of an asset.  In general terms, the basis of an asset is initially determined by the purchase price but may be increased by capital improvements or decreased by depreciation or other deductions.  When an asset is sold, the difference between the sale price of the asset and its basis will determine the capital gain or loss for income tax purposes.

If an asset is gifted, the basis of the asset transfers from the transferor to the recipient of the gift.  In other words, the new owner retains the former owner’s basis.  On the other hand, if an asset is transferred at death, whether by will, trust, or other means, the basis of the asset for the recipient will generally be modified to the fair market value of the asset at the date of death.  For assets that appreciate in value, the basis at death is significantly higher than the prior owner’s basis, which is why this modification is often referred to as “step-up.”
Examples of capital gain amount based on type of transfer:

Scenario:  S bought a house in 1980 for $100,000 (assume no changes in basis since then).  The fair market value of the house is now $200,000.  P acquires the house from S, and then sells the house 6 months later for $220,000. What would the consequences be in each transfer scenario?

Gift:  If P receives the house from S as a gift during S’s life, P will have the same basis as S, which is $100,000.  When P sells the house, P will have a capital gain of $120,000.  ($220,000 sale price – $100,000 basis = $120,000 gain)

Transfer at Death:  If P receives the house from S after S passes, P’s basis will be the fair market value at the time of S’s death, which is $200,000. When P sells the house, P will have a capital gain of $20,000.  ($220,000 sale price – $200,000 basis = $20,000 gain)

This difference in capital gain amount could lead to a significant difference in the amount of capital gains tax owed for the property sale.  Due to this common type of capital gain tax concern, many estate planning professionals will recommend keeping appreciated assets and transferring them at death, rather than transferring these assets by gift during a person’s lifetime.

This type of recommendation should be balanced against the many reasons individuals engage in lifetime gifting, which is reduction of estate taxes, asset protection, and witnessing the next generation’s enjoyment of assets during the transferor’s lifetime.

Each family and each situation is different.  Your estate planning attorney and your accountant can provide you with specific advice for your situation to address your concerns and optimize your transfer of assets to the next generation in the most tax efficient manner.

© 2023 The Business News. Northcentral and Westcentral editions. Reprinted with permission.

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This document provides information of a general nature regarding legislative or other legal developments, and is based on the state of the law at the time of the original publication of this article. None of the information contained herein is intended as legal advice or opinion relative to specific matters, facts, situations, or issues, and additional facts and information or future developments may affect the subjects addressed. You should not act upon the information in this document without discussing your specific situation with legal counsel.

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