For many years, the general rule of thumb in estate planning has been that an individual should gift assets during his or her lifetime. Lifetime gifting can offer many benefits. Most significantly, any future appreciation in the gifted asset is removed from the estate.
In 2015, an individual can transfer up to $5.43 million during his or her life without incurring any gift tax liability. This amount is often referred to as the "exemption amount," and it is indexed yearly for inflation. Upon death, the exemption amount translates into an estate tax exemption, meaning that $5.43 million (also indexed for inflation), less what has been used during the individual's lifetime by making gifts, can pass free of estate tax.
The Narrowing Gap Between Estate and Gift Tax Rates
Recent changes in the law have made the income tax consequences of estate planning increasingly relevant. The state tax liabilities, basis issues, ages, and life expectancies of the donor and donee must be considered, and there are tax planning techniques that may allow an individual to take advantage of lifetime gifting while reducing future income tax liability.
Each individual has a "basis" in every asset he or she owns. When an individual sells an asset, he or she must pay income tax, often at the capital gains tax rate, on the difference between the asset's sale price and his or her basis in the asset. The basis is usually the price paid for the asset; however, when an individual receives an asset as a lifetime gift, the individual takes a "carryover" basis equal to the donor's basis in the property immediately prior to the gift (increased by any gift tax actually paid by the donor upon transfer). Conversely, when an individual dies owning an asset, the recipient's basis in the asset is adjusted to reflect the value of the asset on the decedent's date of death, which in many cases results in a "stepped-up" basis.
Historically, estate tax rates have been significantly higher than capital gains tax rates. Thus, it was generally preferential to make lifetime gifts rather than hold an asset until death in order to receive a stepped-up basis. However, recent legislation significantly lowered the top federal estate tax rate from 55% to 40% and increased the top federal long-term capital gains tax rate from 15% to 23.8% (20% plus a 3.8% tax to fund the Affordable Care Act, often referred to as the "Medicare Tax"), narrowing the gap between the estate tax rate and the capital gains tax rate.
To illustrate, assume Parent, a New York City resident, owns an apartment in the city that she bought 40 years ago, currently worth $5.43 million with a basis of $100,000. If Parent gives the apartment to Daughter in 2015, Parent will owe $0 in federal gift tax. If the apartment appreciates to $12.43 million by the time of Parent's death in the year 2017, then the gift has saved roughly $2.2 million in federal estate tax (40% of the $7 million in appreciation, less the deduction for state-level estate taxes paid). In addition, New York also imposes a separate state-level estate tax (with an indexed exemption that will not match the federal exemption amount until 2019) and would levy its own estate tax bill of approximately $1.45 million, bringing the total tax to roughly $3.65 million.
However, assume that two years after Parent's death, Daughter needs to sell the apartment. Daughter has a carryover basis of $100,000 in the apartment, and the apartment has appreciated further and is now worth $13 million. Federal income tax on $12.9 million would be due, which at the top current long-term capital gain rate of 23.8% would result in approximately $3.07 million in federal income taxes for Daughter. The income tax effect is further exacerbated if we assume Daughter is a New York City resident with a top aggregate federal, state, and city effective capital gains rate of 36.5% – this bumps her total tax bill up to approximately $4.7 million. Thus, in this scenario, making a lifetime gift of the apartment was not the tax-optimal choice.
Before the narrowing of the gap between estate/gift and capital gains tax rates, the decision whether to gift assets during one's lifetime rather than retain such assets until death for the basis step-up was simple – lifetime gifting was almost always the preferred choice. However, in the current era of ever-increasing income tax rates, a careful analysis of all of the relevant factors, such as state tax liability, basis issues, the age and life expectancy of the individual owning the assets, and the age and financial situation of the individual likely to receive the assets, is critical. In addition, there are certain tax planning techniques that may allow an individual to take advantage of lifetime gifting while at the same time reducing future income tax liability.