Starting the New Year with Good Estate Planning Gift Giving Strategy

Most people wait until late in the year to focus on the gift giving that’s part of their financial and Estate Planning. It’s smarter and shrewder to think about their estate planning giving strategies early in the year and execute gifts through the year to maximize the benefits.

The federal estate tax used to drive most giving strategies. Even solidly middle-class families had to worry about the estate tax and used gifts to maximize the amount of after-tax wealth received by loved ones. The revolution in estate taxes since 2000 changed that focus. For the small percentage of the population with taxable estates, gifts to reduce estate taxes still are a valuable strategy, and this discussion will help them. There also are some states with estate or inheritance taxes that are imposed at much lower levels than the federal estate tax, and families in those states still should consider gifts to reduce those death taxes.

For others, helping loved ones and seeing the effects of your generosity are the main reasons for lifetime gifts. You want to make these gifts with tax efficiency and with a focus on income taxes, especially capital gains taxes.

Making gifts wisely and with tax efficiency isn’t as easy as simply handing over a check. A little planning increases your family’s after-tax wealth and maximizes your gifts’ impact. The tax man is a participant in every gift you make. Reduce his role by knowing the rules and planning for opportunities throughout the year.

We start with some fundamental rules.

The estate tax exemption was set at $5 million per person in 2012, and is indexed for inflation. For 2016 the exemption is $5.45 million. Married couples can use the portability provisions to jointly exempt twice that amount, $10.9 million. The lifetime exemption also can be used against gift taxes. If you make more than $5.45 million of taxable gifts during your lifetime, gifts above that amount are taxable. Plus, any use of the lifetime gift tax exemption reduces the estate tax exemption. So, you have a combined lifetime estate and gift tax exemption, known as a unified credit, of $5.45 million in 2016. You can give that amount tax-free now or later, and it rises with inflation annually.

You also can give some money and property free of estate and gift taxes without using the lifetime exemption using the annual gift tax exemption. In 2016 you can give up to $14,000 of money or property to each person you want without it being taxable or reducing your lifetime estate and gift tax exemption. (The $14,000 is indexed for inflation.) A married couple can jointly give each person up to $28,000 gift tax free.

The gifts can be of money, property, paying expenses on someone’s behalf, or any other transfer of wealth. The value of a gift of property is its fair market value on the date of the gift. The $14,000 limit applies to the total of all gifts to a person during the year, not to each individual gift.

To qualify for the annual exclusion, a gift must be of a present and complete interest. Qualified or restricted gifts or ones that you legally can ask to be returned aren’t eligible for the exclusion.

Gifts to a trust qualify for the annual gift tax exclusion when they are gifts of present interests. This generally means the trust must have a Crummey power that entitles the beneficiary to take the money out of the trust within a specific time after the gift was made, usually 30 days. After the time passes, the property stays in the trust subject to its rules.

There’s an unlimited gift tax exclusion for qualified medical and education expenses. These gifts don’t reduce the lifetime exclusions or the annual gift tax exclusion. Payments must be made directly to the provider of the services, not to the person receiving the services.

Qualified education expenses are tuition, books, fees, and related expenses at any level of schooling. Room and board don’t qualify. Qualified medical expenses are any that meet the income tax definition of deductible medical expenses. You can find more details in free IRS Publications 709 and 950, available free at www.irs.gov or by calling 800-TAX-FORM.

Those are the basic estate and gift tax rules.

Here are estate strategies to maximize the benefits of these rules and avoid some pitfalls. These strategies also reduce income and capital gains taxes.

Estate Planning Strategy #1

Don’t give loss property. The beneficiary of a gift of property will have a tax basis in the property. When the property eventually is sold, the capital gain or loss will be the amount realized on the sale minus the basis.

When you give property with a value less than your tax basis (which usually is your cost), the beneficiary’s basis will be the lower of your basis and the current market value. That means the beneficiary will reduce the basis to current market value, and the loss incurred while you owned the property won’t be deductible by anyone.

It’s better for you to sell the loss property and deduct the loss on your tax return. Then, you can give the after-sale proceeds or other property to loved ones.

Estate Planning Strategy #2

Give appreciated investment property during a market decline. You can give more property and more future wealth when the value temporarily declines. For example, when shares of a mutual fund decline from $60 to $50, you can give 280 shares tax free under the annual gift tax exclusion instead of 233.33 shares. If the recipient holds the shares, after the market recovers you’ve given more wealth tax free simply by timing the gift. That’s a reason why it is a mistake to wait until year end to make gifts. Determine early in the year the amount you want to give, and then look for a good time during the year to increase the impact of the gift.

Estate Planning Strategy #3

Give property that’s likely to appreciate. You want to remove future appreciation from your estate so you won’t have to pay income, capital gains, estate, or gift taxes on it or use up your lifetime exemption to transfer it. So, when you have a choice, give loved ones property you believe will appreciate.

The strategy provides significant capital gains tax benefits when the beneficiary is in a lower tax bracket than yours. When the property eventually is sold, the beneficiary will pay capital gains taxes on the appreciation. Those gains will be off your income tax return and taxed at a lower rate than you would have paid. So, you passed more after-tax wealth by paying attention to which property you gave.

Estate Planning Strategy #4

Don’t give property that already significantly appreciated. At first it appears a good idea to give a loved one property that appreciated a lot while you’ve owned it. If the recipient is in the 0% or even 10% capital gains tax bracket, they might sell the property and pay significantly lower capital gains taxes than you.

There are two other considerations. First, be sure that selling the property wouldn’t put them in a higher bracket.

Second, consider instead holding the property and having it pass through your estate. When appreciated property is received as a gift, the beneficiary takes the same tax basis the previous owner had. That means all the appreciation is taxed whenever the beneficiary sells it, unless the beneficiary is in the 0% tax bracket.

When property is inherited, however, the beneficiary’s tax basis is increased to the fair market value on the date of the owner’s death. That means if you hold highly appreciated property for life and let loved ones inherit it, the appreciation during your lifetime never is subject to capital gains taxes. That’s why it often is better to hold highly appreciated property and use other assets to make gifts.

Estate Planning Strategy #5

Give income-producing assets. Most of the time, the person considering gifts is in a higher tax bracket than the likely recipients. Also, some assets the person owns are generating taxable income in excess of his or her needs.

In these cases, it makes sense to give income-producing assets instead of cash or other property. The income is shifted to a lower tax bracket, keeping more after-tax wealth in your family. Also, a gift of income-producing property could induce the beneficiaries to recognize the benefit of having an asset that generates regular income. They might hold the asset and spend only the income for a long time instead of selling it and spending the proceeds right away.

You also could make the gift through a trust so the beneficiaries aren’t able to sell the property before you believe they should.

When giving to youngsters, keep the kiddie tax in mind. When a child is under age 19 (or under 24 if a full-time college student), the child’s investment income is taxed at his or her parents’ highest tax rate when the child’s investment income exceeds $2,100 (indexed for inflation each year). We’ll discuss the Kiddie Tax in more detail in a future visit. Details also are in IRS Publications 17 and 929 and in the instructions to Form 8615 available free at www.irs.gov or by calling 800-TAX-FORM.

Estate Planning Strategy #6

Plan at least a year’s worth of gifts. I usually favor making gifts early in the year instead of the end-of-year holiday period that most people favor. Early year gifts ensure the gifts are made and the year’s income and appreciation are out of your estate or off your tax return. As mentioned earlier, you also can look for a time during the year to maximize the value of a gift, such as a market decline.

Another good strategy can be to make gifts late in the year and again early the following year. This is especially advantageous when giving property that has to be appraised. An appraisal costs money. If you give interests in that property in December and again in January, then you probably have to pay only for one appraisal.

RW February 2016.