In the “old days” people made annual gifts to minimize taxes. Today, that’s probably going to increase taxes for most families.
Lifetime gifting may be a good strategy to minimize estate tax, but it can have just the opposite result as to income tax. With the high estate tax exclusion amount ($11,400,000) and the top income tax rates at 37% (plus a surtax), the focus in estate planning has changed. The majority of Americans don’t have to worry about estate tax under current law, so now the focus should be on their exposure to income tax.
There is no income tax on a gift or bequest. It’s when an heir sells an appreciated asset down the road that it makes a big difference on whether the heir received the asset at the death of his donor or during the donor’s lifetime.
The issue has to do with the income tax “basis” of the asset being sold. Uncle Sam taxes us on the difference between what we sell an asset for and what we are deemed to have paid for the asset, our basis. So, if I bought an asset, then my income tax basis is what I paid for it (with some adjustments like depreciation that we won’t worry about here). If I was given the asset, my basis is determined in a different manner. If I received the asset during the lifetime of the donor, then I take his basis. Whatever he paid for the asset, his basis, carries over to me. “Carry-over basis.”
By contrast if I inherited the asset, Uncle Sam gives me a break. My basis in the asset is stepped up to the value on my donor’s date of death. “Stepped up basis.” Since there is no income tax when I inherit, this doesn’t make any difference then. But, when I sell the asset down the road it can make a big difference as to how much capital gains tax I pay.
The moral of the story: making a gift of an appreciated asset during your lifetime might not be smart from a tax standpoint. You have to consider both the effect on the estate and the income tax. It can get a little complicated!