As the holidays race toward us, our thoughts turn to the perfect gift for everyone on our list. It is also the time of year when many of our clients think about making larger gifts to family members and want a refresher on the gifting rules.

Although understanding the gift tax rules is important, there are other factors beyond those rules that should be considered if you are considering making a large gift, whether during the holidays or at any time of year. One of the least understood but more important factors is basis, which is impacted by whether an asset is gifted or inherited.

Basis is generally the tax cost of an asset, which is used to compute capital gain or loss when that asset is sold. Gifts of cash have no capital gain tax implications, but gifts of assets like stock or real estate that have a tax cost and have appreciated in value since the asset was purchased carry with them significant capital gain tax implications if and when that asset is sold. Federal income tax rules treat the tax “basis” of property differently depending on whether it is received by gift during life or inherited at death, and these differences impact the amount of future capital gains tax that will be paid upon a sale. Understanding these differences will help you evaluate whether to give a certain gift during your lifetime or wait to give that gift after your death.

The general rule is that when an asset is transferred by gift, the gift recipient (the donee) takes the gift giver’s (the donor’s) tax basis in that asset, often referred to as “carryover basis.” If, as is often the case, the donor’s tax basis is lower than the current value of the asset at the time of the gift (i.e. the asset has appreciated), the unrealized gain “carries over” to the donee. A later sale of the asset by the donee will result in the donee having to “recognize” this built-in gain and pay capital gain tax on the difference between the tax basis and the sale price. If you are giving a gift of an asset that has appreciated in value, you should give the recipient any records you may have that document the asset’s purchase price and anything else that may be relevant to your tax basis in that asset.

For example, if you purchased Microsoft stock for $100,000 many years ago, it is now worth $300,000, and you give your Microsoft stock to your son as a gift for the holidays, your son’s tax basis in the Microsoft stock is $100,000, and he still has your $200,000 unrealized gain. If your son later sells the stock for $320,000, his long-term capital gain is $220,000, and his combined state and federal capital gain tax will be anywhere from 5% ($11,000) to 25% ($55,000).

The general rule for an asset that is inherited from a deceased person is very different – and generally more favorable to the recipient. An asset acquired from a deceased person has a basis equal to the asset’s “fair market value” on the date of the deceased person’s death. This is commonly called a “step-up” in basis when the asset appreciated during the decedent’s lifetime, but it can also be a “step-down” if the asset declined in value. The step-up in basis essentially wipes out all pre-death unrealized capital gains, which can result in significant capital gain tax savings if the recipient intends to sell the asset.

For example, if you hold your Microsoft stock in which you have a tax basis of $100,000 until you die and leave it to your son in your Will or Trust, and if the Microsoft stock is worth $300,000 at your death, your son’s tax basis in the Microsoft stock is “stepped up” to $300,000. If he sells the stock shortly after your death for $320,000, his gain is only $20,000, and his combined state and federal capital gain tax will be anywhere from 5% ($1,000) to 25% ($5,000). Holding the asset until death has effectively avoided capital gains tax on the $200,000 of pre-death appreciation.

When considering whether to gift appreciated assets prior to death, take the following into account:

• Gifting allows the donor to shift wealth and may reduce the estate tax payable at the donor’s death, but the carryover basis may result in significant capital gain tax if the gifted assets are sold. Consider gifting assets with little or no built-in capital gain or cash.
• Retaining assets until death is usually more favorable for low-basis, highly appreciated assets, to take advantage of the step-up in basis on inherited assets, particularly if the donor’s estate is unlikely to incur estate tax.
• Consider the estate tax rates. For example, if the donor’s estate will not pay federal estate tax (because the donor’s estate is less than $15 million in value) but is likely to pay Massachusetts estate tax (because the donor’s estate is over $2 million in value), the estate tax rates in Massachusetts (which range from 6% to 16%) may be lower than the capital gain tax that would be paid if the same asset was given to the intended recipient prior to death and later sold.
• The interplay of the federal estate and gift tax exclusions, portability of the federal estate tax exemption, and state estate taxes can influence whether lifetime gifts or inheritance provide a better tax outcome.
• Different types of assets have different rules about basis. For example, tax-deferred assets such as traditional IRAs, deferred compensation, etc. do not receive a basis step-up at death and remain taxable as ordinary income when collected by beneficiaries.

In short, deciding whether to gift or hold an appreciated asset requires looking beyond gift tax rules to the often-overlooked impact of basis and future capital gains taxes. The most tax-efficient strategy will depend on the type of asset, its built-in gain, your overall estate, and the federal and state tax landscape. Because these rules are complex and highly fact-specific, consulting with an estate planning or tax professional before making significant gifts can help ensure your generosity achieves its intended result. If we can assist you in determining the best approach for your gifting this holiday season, please do not hesitate to reach out to one of our attorneys.

Attorney Leah A. Kofos is an attorney with the Dedham firm of Samuel, Sayward & Baler LLC, which focuses on advising its clients in the areas of trust and estate planning, estate settlement, and elder law matters. This article is not intended to provide legal advice or create or imply an attorney-client relationship. No information contained herein is a substitute for a personal consultation with an attorney. For more information visit ssbllc.com or call 781-461- 1020.

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