Gifting as a General Concept?

In some cases, estate planning may involve the idea of divesting yourself of assets, that is to say, giving away your money or assets to others, perhaps your children or grandchildren, during your lifetime. This can make sense, especially if you are concerned about all your assets being used to pay for long term nursing care as you get older, generally known as Medicaid planning. While gifting can be advantageous in certain situations, understanding how the capital gains tax works and the concept of step-up in cost basis is paramount for leveraging tax benefits effectively.

What is a Capital Gain?

Simply put, a capital gain is the amount an asset appreciated in value from the time you acquired it until the time you sold it. For example, if you purchased a home in 1985 for $200,000 and sold it for $500,000 in 2024, you would have a capital gain of $300,000. Whether all of that is subject to tax is based on a number of factors, but the gain is $300,000.

What is Step-Up in Cost Basis?

Step-up in cost basis refers to the adjustment of the value of an asset, such as real estate, to its current market value upon inheritance. This reset eliminates the capital gains tax liability on the appreciated value up to the date of transfer, offering significant tax savings. What this means is that if you inherit the property (as opposed to receiving it by way of a gift), you gain the benefit of eliminating any capital gain that may have accrued up until the time of the death of the owner of the property.

No Step-Up in Cost Basis for Gifts

Unlike an inheritance that results in a step up in cost basis of a particular asset, the same is not true if you acquire the property by way of what is known as an inter vivos gift (a gift made during the lifetime of the donor). If you acquire property by way of an inter vivos gift, you will assume the cost basis of the person who gave you the gift. This is how it would work:

Scenario A:

·      Mom and dad bought their home in 1985 for $200,000. That is the cost basis for that asset, although it could be higher if they made certain capital improvements, but we will keep it simple for purposes of this example.

·      Mom and dad give you the property in 2023 and you decide to sell it in 2024 for $500,000.

·      In this case you would realize a capital gain of $300,000 ($500,000 less $200,000).

Scenario B:

·      Mom and dad bought their home in 1985 for $200,000. That is the cost basis for that asset.

·      Mom and dad die in 2023, you inherit the property, and you decide to sell it in 2024 for $500,000.

·      In this case there would be no capital gain because the cost basis would be the fair market value of the property when the parents died, presumably $500,000.

Consultation with Financial and Legal Professionals

Given the complexity of tax laws and the intricacies of real estate transactions, seeking guidance from financial and legal professionals is crucial when implementing gifting strategies. These experts can provide tailored advice to maximize tax benefits and navigate potential pitfalls.

Conclusion

Real estate gifting, coupled with understanding step-up in cost basis, offers a powerful avenue for wealth transfer and tax optimization. By employing strategic gifting techniques and seeking professional advice, individuals can unlock significant tax benefits while preserving their legacy for future generations.