Watch out for the gift tax trap in the new tax law
Finally, the much anticipated changes in federal estate tax law — death taxes — as they are often referred to, were passed by the House and Senate and went into effect Jan. 1, 2018.
The good news is; the new legislation substantially increases the amount allowed to calculate taxes on estates, where no federal tax would be applied. The new estate tax law stipulates that a single person could die owning up to $11.2 million without paying the dreaded death tax and for married couples the amount has been increased to $22.4 million, if a timely portability election was made after the death of the first spouse to die. Both of these changes go went into effect Jan. 1.
As with anything having to do with taxes, caution needs to be taken. Lack of attention to the new details in the law can lead to misapplication of the changes which would create significant tax consequences for the beneficiaries of the estate as it relates to gifting.
Especially important for those tracking the amended estate tax law, is to be aware that the new version will leave in place the laws that stipulate; when a person dies, the cost basis of the assets — not including IRAs and retirement plans, of course — would be increased to the value of the asset at the date of the owner’s death. This is referred to as a step up in basis; thus the capital gain or profit element, created in the assets overtime, is then forgiven at the time of the owner’s death.
However, any misunderstanding that leads to misapplication of these laws could ruin this new benefit and lead to significant taxes due.
Here is how that could happen: the benefit of the forgiveness of gain, for income tax purposes, at the owner’s death, is lost if the owner were to gift the asset before the owner’s death. As with most estate tax issues, acting without clarity can create a treacherous error which would cause a triggering of substantial taxes on the subsequent sale of the gifted item.
Since most people have estates that are valued at less than the new limits I called upon Randy Spiro, an estate planning attorney in Beverly Hills, Calif., to explain how the revisions in the federal estate tax law, might have the potential of being misapplied, as it relates to gifting.
“If a single person bought real estate for $300,000, he/she may have been told that if he/she gives it away to his/her children at a time when it is worth $500,000, then the entire future increase in value of that asset, up to the time of the owner’s death, will be eliminated from the owner’s estate because the increase in value occurred while the children were the owners,” Spiro said.
“Strategies of giving away assets to children or other family members are not necessary in these situations, and such strategies have the negative effect of forfeiting the forgiveness of gain at the owner’s death,” he added.
Why? Because the asset only qualifies for gain forgiveness, and for the new cost basis, if the owner still owns the asset at his or her death. In simple terms; the asset cannot be gifted during the life of the owner and still receive the benefit of step up in basis at the death of the person who previously made the gift.
Some people have created advanced estate planning strategies such as sales to an intentionally defective grantor trust, family limited partnerships, qualified personal residence trusts and granter retained annuity trusts. These strategies are designed to either freeze or decrease the value of assets that will later be subject to federal estate tax.
Spiro added, “Let us assume that a person has used one or more of these strategies during the time when the amounts that were exempt from federal estate tax were much lower, for example; on estates valued at $5 million and $10 million in 2011. Assume further, that person’s estate is now less than the new higher limits — which are referred to as exemptions — even without these value reduction techniques. Then the effect of the attempted tax reduction techniques will actually prevent the full use of the step up in basis at death for income tax purposes with no corresponding estate tax benefit.”
To avoid this potential gift tax trap; anyone considering making lifetime gifts — large or small — needs to be fully aware of the consequences of their gifting and to apply the appropriate estate planning strategies using current estate tax law.
Be sure to discuss your intentions thoroughly with your legal adviser before proceeding with any proposed gifting action.