Lifetime Gifts and Capital Gains Tax Implications

With the increase of the federal estate tax exemption to $5,340,000 in 2014, most Arkansas taxpayers are not subject to federal estate taxes. The focus for estate planning attorneys has now shifted to the income tax (capital gains tax) implications that arise when wealth passes to your loved ones. Without thinking about the income tax implications, many times elderly people are told the transfer of real estate to children during their lifetime is a good idea in trying to avoid probate and to make things easier for loved ones. Even uninformed realtors, attorneys and other financial advisers sometime make such a recommendation without knowing the tax impact. However well-meaning, this uninformed strategy can have big income tax results for the recipients of these lifetime gifts.

Basis Rules:

It is important to understand the following income tax basis rules for calculating gain or loss:

  • Lifetime Gifts: Those who receive lifetime gifts take a carryover basis in the property received. The carryover basis is determined by what the maker of the gift originally paid for the asset plus any improvements made to the property.
  • Bequest at Death: Beneficiaries who receive assets at the decedent’s death get a step up in basis to the date of death value of such assets received.

 Illustrating How These Rules Operate

Example: Dad wants to avoid probate and to transfer during his lifetime his real estate to his son. Dad purchased his house in the 1970s for $17,000 and made improvements during the years of $23,000. As a result his adjusted basis is $40,000. The house is now worth $540,000.

Since this was a lifetime gift, Son takes a carryover basis for the house of $40,000. Son sells the house for $540,000 shortly afterwards and has a capital gain of $500,000 which he surprisingly and shockingly learns from his accountant will cost him $100,000 (20% x $500,000) in federal taxes alone. His accountant tells him there will also be state income taxes on this gain. Son is a Arkansas resident, he will pay an extra $24,500 in Pennsylvania income taxes.  Total Taxes: $124,500.

  • Form 709:  Any lifetime gifts of over $14,000 require the filing of a Form 709, United States Gift Tax Return, in the year of the gift.  It should also be noted the IRS now checks recorded deeds

Alternate Universe: Dad consults with his tax/estate attorney who drafts a Will/Trust that provides for the transfer of his house at death to Son. Son has a basis of $540,000 upon his receipt of the house from the estate. Son, now sells the house and has zero capital gain (Sale Price $540,000 less basis of $540,000 = 0)!

  • Note: Arkansas does not have an inheritance tax.

Medicaid Caveat

This discussion does not explore any Medicaid qualification issues and such considerations should be explored with an elder law attorney specializing in this area.

Bottom Line

The main point is that making transfers and only considering probate can result in a large tax bill for your family. Each taxpayer’s particular situation is unique and should be looked at by trained professionals to develop a workable, comprehensive and integrated estate and income tax plan.