Upstream Gifts: He Gon Give It to YaUpstream Gifts: He Gon Give It to Ya

The new tax law increases both the federal estate and the federal gift tax exemption to $11.18 million per person. While this is the most generous exemption to date, most people in the United States were already well-below the 2017 exemption amount of $5.49 million per person.

It’s likely that many clients, or their loved ones, will fall into the 99 percent of the population that don’t face federal estate taxes, even if they live past Dec. 31, 2025, when the exemption amount decreases to $5 million. Therefore, income tax basis planning may become a more significant part of a client’s estate plan. If a client’s parents, or other trusted elderly relatives, have an estate under the exemption amount, one strategy that can be implemented for income tax basis planning is making gifts of low basis assets upstream to the older generation.

Upstream Gifts of Low Basis Assets Strategy

This strategy is sound income tax planning because the Internal Revenue Code provides that if a person inherits property from a decedent, then the recipient of the property may use that property’s fair market value as of the date of the decedent’s death as the recipient’s basis in the property, thus reducing capital gains tax on a subsequent sale or providing a refreshed basis for depreciation purposes in connection with property used in business.

Example 1: Let’s assume that an individual owns an investment property that he bought for $100,000; it’s now five years later and the property is worth $1 million. If the property were sold while the individual is living, there would be a taxable gain of $900,000. To avoid this gain, the individual may gift the investment property to his elderly father who has a net worth of $1.5 million. At the father’s death, the investment property receives a step-up in basis equal to the then fair market value of the property. Assuming the elderly father’s net worth, including the investment property, is under $11.18 million, no federal estate tax would be due. And as long as the father’s estate is under the state tax exemption, there would be no state estate tax due either.

For this strategy to work, the parties must have a trusting and honest relationship because the father would need to execute estate planning documents to ensure that his son would receive the investment property back at the father’s death. Specifically, the individual’s father has the ability to transfer the investment property to anyone. The child will have no control over what his father does with the property, but with an honest and trusting relationship, the child might trust his father to follow the child’s wishes.

Separately, it should be noted that if the parent dies within one year of receiving the assets from a child and the assets pass back to that child, those assets won’t receive a basis adjustment at the death of the parent. This issue is addressed in the next example. 

Upstream Strategy Using a Trust

Example 2: Considering the above facts, the child might alternatively create a trust for the benefit of his father and then fund the trust with the low basis property. The son must grant his father a general power of appointment over the trust, which can be exercised such that the trust assets will continue to be held in trust for the benefit of the son so that the assets receive not only a step-up in basis but also are protected from the son’s possible future creditors. Furthermore, by using a trust that would be generation-skipping transfer tax exempt, the transferred assets would then avoid any transfer tax at the son’s later death.

Here, the one-year limitation discussed in Example 1 is avoided because the assets pass to a trust for the benefit of the original donor. Alternatively, this one-year limitation can be avoided if the assets pass to the child’s spouse or descendants. Separately, consider the possible exposure of the assets to the father’s possible creditors (or depletion for long-term care). 

Clients with Elderly Relatives

The new tax laws create many different avenues to achieve income, gift and estate tax savings. Advisors who have clients with elderly relatives that have estates below the exemption amount should discuss the implementation of the above-described strategies.