To gift or not to gift – it can be a complex question for families that hold appreciated assets and are (or may be) exposed to estate tax. Not gifting means keeping the asset or doing something to cause the asset to be included in an estate for estate tax purposes. Gifting means the opposite: making a lifetime transfer to remove the asset and future appreciation from an estate to save estate tax.
This dilemma arises due to the fact that upon death there is an income tax cost basis step up on all assets included in an estate. For example, if you have a $1 million gain in Apple stock and you die, the gain is erased to $0. What would have been sold yesterday at a tax cost of nearly $250 thousand ($1 million x 25%) can be sold after you die for a tax cost of $0. This makes it appealing to tempt estate tax fate and hold as much into your taxable estate as possible. The risk, of course, is fate not being on your side and ending up with more estate taxes than originally planned.
This piece outlines areas of consideration for individuals who are considering a gifting strategy and determining what that strategy should look like. A financial advisor can be particularly helpful in providing advice around the best approach to a gifting strategy.
Gifting Now vs. Later?
There are several reasons why the timing might matter. First, the new 2018 tax law doubled the federal estate tax exemption from $5.6 million to $11.2 million per individual ($22.4 million exemption for a married couple) for decedents passing before 2026. On January 1, 2026, the exemption will return to the pre-2018 exemption levels ($5.6 million per person, adjusted for inflation) unless Congress acts to extend the new exemption amounts. Second, with many assets appearing “rich in price”, what you give and how you give it matters far more than first meets the eye.
What Inputs Should Be Considered? Capital Gains Rates, Taxes, etc.
Ignoring more important client specific goals, facts, and wealth transfer objectives, the question of gifting or keeping can generally be answered with arithmetic. However, an ever-changing political landscape (capital gains rate, estate-gift tax rate, estate-gift tax exemption, etc.) can make that more challenging. These have enormous implications to financial models and, in the blink of an eye, can change the entire analysis. However, we’ve outlined here are few areas to consider.
Tax Calculations for Estate Gifting Decisions
The more an asset is subject to estate tax (value exceeds exemption), the more appealing it is to gift the asset
It is reasonable to assume the estate tax rate will remain higher than the capital gains tax rate for the foreseeable future. Assuming this to be the case, it makes gifting assets subject to estate tax more appealing.
The higher the amount of unrealized gain, the more appealing it is to retain the asset
This speaks for itself. The higher gain means a bigger step-up and, therefore, a bigger tax benefit when the gain is erased.
The higher the expected return on the assets, the more appealing it is to gift
Ditto to what is said in rule #1. Higher returns drive higher values, which makes gifting appealing in a taxable estate scenario.
The longer the time horizon, the better it is to gift
More time means more time to grow and, hence, a higher value subject to estate tax at death.
The longer an asset is held after it is inherited (post death), the more appealing it is to gift
The longer an asset is held, the longer it is until the tax liability associated with a sale is paid. Therefore, the present value of the cost is less. Assets held for generations (emphasis on plural) may never incur capital gains tax and, if perpetuity is part of the assumptions, gifting is usually the answer.
Where you reside (more importantly the owner of an asset) matters greatly. Residents of high tax states like Minnesota, New York, and California have more to think about than residents of Nevada or Arizona, both in terms of income taxes today and, in the case of states like Minnesota, state level estate taxes in the future.
Additional Gifting Considerations
Being choosy and deciding what to give is key in any effective strategy. Gifting high cost basis assets (low % unrealized gain) with good growth potential remains appealing, as does gifting assets with long time horizons.
Focus on the timeline
For young clients or assets that will be held long after death, gifting is a good strategy. What does this mean for planning? Start gifting programs now and don’t wait until estate taxes become a problem.
Grantor retained annuity trusts
Consider using grantor retained annuity trusts to shelter asset growth from estate tax, but cause the asset to be included in an estate should a passing happen during the term of the trust…in other words, when death happens sooner than originally planned.
Hedging to manage concentrated risk
Maintaining a concentrated position to preserve a cost basis step-up at death does not come without risk. It is possible to hedge downside risk, but the cost of hedging should be compared to the tax savings that come with the basis step-up.
Creative use of debt
Consider using debt to gift cash today, thereby keeping low basis assets in an estate. The right circumstance for this strategy is when a client does not have a long-life expectancy. Lending can be done in combination with a hedging transaction, but further discussion is beyond the scope of this article.
Creative portfolio construction
Consider using a custom separate account equity index portfolio= as a way to reduce the income tax liability in moving a portfolio from one or several securities into a more diversified equity portfolio.
Families should “run the numbers” to see whether a lifetime gifting program makes sense. Ultimately, objectives are key and should not override any projection of tax savings. Lifetime spending needs, future market assumptions, projected lifetimes, and preparedness of the next generation are just a few of the many non-tax assumptions that need to be considered.
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