Upstream Gifting and Gifting Gains
What is upstream gifting?
What if you gift your elderly parent an asset with massive capital gains? What if they held them until they get the step-up in basis at death, and then you inherit them back? No one ever pays the capital gains! This is upstream gifting!
While death and taxes are not fun to think about, both will happen. Upon death, when you inherit an asset, its basis gets stepped up. Also, you are allowed to gift anyone 16k a year… even a parent! And if we put the two facts together…
Why not gift away a low-basis asset and get it back a few years later with a step up in basis? Let’s talk about upstream gifting and how it might help you erase some capital gains on highly appreciated assets.
An Example of Upstream Gifting
Let’s say you have a mother who is elderly and will pass on in the next few years. If she is set financially and doesn’t need money, why not gift anyway to get a tax break?
Imagine you have 16k of stock that you paid 1k for. If you sell it, you pay 15k in long-term capital gains tax. Instead, use your yearly gift exclusion to give it to Mom. That is, directly transfer the shares from your brokerage account to hers. She gets the pleasure of paying taxes on the dividends each year, hopefully at her lower rate.
Then, you get the 16k in stock back (plus growth) when she passes. Maybe it is worth more now, but the basis of the stock resets the day she dies. It gets a step-up in basis. When you gave it to her, it kept the 1k basis since gifts retain their basis. After death, however, assets get stepped up and capital gains erased. That is, the stock now has the basis on her day of death, so instead of 15k of capital gains taxes, you owe zero if you sell the stock right after you inherit it back.
This gain gifting works well when you keep under the yearly gift exclusion of 16k a year. However, you and your spouse can give 64k to your mom and dad, as this is 16k x 4. You will have to fill out a gift splitting form with your taxes, but you do not lose out on your lifetime estate tax exclusion.
Directly transfer the shares from brokerage account to brokerage account. No selling to cash and transferring that.
Highly appreciated real estate is also possible to think about with upstream gifting, but you likely would consume some of your lifetime estate tax exclusion. This may or may not be an issue upon your death (depending on the size of your estate and how much they cut the estate tax exclusion in the future).
Understand that when you gift an asset, the basis transfers. You can give gifts to anyone. If you give your kids (in a lower capital gains bracket) appreciated assets, they can sell them and recognize the capital gains at a lower tax rate.
Let’s look at an example of gifting to your kids. This is called downstream gifting.
So here, assume you are in the 23.8% capital gains tax bracket, but your kids are under the 12% federal income tax bracket for ordinary taxes. They still have some room in their 0% capital gains bracket. If you gift them appreciated securities, they may be able to sell the asset, recognize the gain, but pay no taxes on it.
When considering downstream gifting, don’t forget about kiddie tax if you claim your children on your tax return. They can still have $2,200 of net unearned income annually, which may help during college age. This gets complicated and is beyond what I want to discuss here.
Giving to your kids is downstream gifting. Giving to your parents is called upstream gifting.
Upstream Gifting to your Parents
Why might you want to gift to your parents?
There are a lot of reasons! First, they might be in a lower capital gains bracket than you are and, like the example above, be able to recognize capital gains at 0 or 15% when you would pay 18.8% (above the NIIT income limit) or even 23.8%. Remember, there is no 20% capital gains bracket; review my bit on Capital Gains if you need to.
Note that the gift must be made at least a year before death. If you gift on the deathbed, the gift reverts without a step-up in basis.
And make sure that Mom doesn’t get a new boyfriend and leave him the assets. After all, once you gifted, they are hers to do with as she pleases!
Other Issues in Upstream Gifting
Step up in basis
You can gift lots of things. Stocks, ETFs, mutual funds can all be moved electronically from account to account. Once the shares are in their brokerage account, the basis should also transfer.
At death, you get a step-up in basis for inherited assets. Instead of the basis recorded, once the custodian receives a copy of the death certificate and transfers the assets to your account, the new basis should be stepped up to the date of death. Hopefully, you die when the market is up, but that’s pretty morbid!
The Usual Point of Yearly Exclusion Gifting
Generally, we think about yearly exclusionary gifting if you are up against the estate tax limit. For example, a couple can give their married child 64k a year. That is, each parent can provide each of the couple with 16k. Of course, the parents will need to fill out a gift-split form when they do their taxes, but this is a way to get money out of your estate.
This usually works best if you give something that will appreciate between now and when estate taxes are due. So, for example, you could put your business in an LLC and then gift shares of the LLC that will be worth much more in 10 years. Then, when you pass, the growth of the assets is in your kid’s name and not part of your estate.
Gifting between Elderly in the Non-Community Property States
Ownership is also a consideration between spouses in non-community property states. There is “gifting” between spouses, but you have an unlimited marital deduction, so there are no limits on intra-marriage gifting.
You get a full step-up in basis of all assets any time either spouse dies in a community property state. Seems like most people don’t understand this, and it can be tricky when you move to a non-community property state.
In non-community property states, have the spouse who will die first own all the low basis assets in their name. Then when the other spouse inherits them, they will get a full step-up, rather than just a ½ step up that you would otherwise get if owned joint.
Don’t Gift Loss Property
Just as a reminder, or take note if you haven’t heard this before, never give loss property. If you have a loss on the asset, sell and recognize the loss and give away the cash.
If you give loss property, the loss doesn’t transfer, and the asset has a split double basis. So don’t worry about the behind-the-scene numbers; just understand that you don’t gift losses. Ok?
Don’t Gift Assets Before Death
While we are on what not to do, don’t gift appreciated assets before death. If you leave them in your will instead (or beneficiary form, trust, or transfer-on-death account), you will get the step-up in basis. If you gift them, their basis transfers, and you lose the step up!
This is a not-infrequent mistake around titling of the home. If you put your children on the title of your home before death, thinking it will be easier to transfer the home, you lose the step-up in basis on the home! Putting someone on the title is a gift of the property; thus, it does not get a complete step up. This can be a massive mistake as each individual gets a 250k free step up in the home value when they sell (or die).
Summary: Upstream Gifting
In summary, you can take advantage of lower capital gains brackets by upstream or downstream gifting to the yearly gift tax exclusion. Don’t gift loss property! Take the loss.
Downstream gifting has the complications of kiddie tax, but upstream gifting has the advantage of step-up in basis upon death. So even if you don’t think you will have estate tax issues, giving highly-appreciated assets to your parent is a consideration.
These maneuvers don’t take time but can save thousands of dollars in capital gains taxes. Not a bad return on investment as every dollar the government doesn’t get is another one to spend or give away.