The 16th Amendment to the U.S. Constitution gives the Federal Government the power to tax the income earned by its residents and citizens, and Massachusetts has an equivalent provision in its state Constitution. For a lot of income, this taxation is fairly straightforward. If there is a 5% tax on income earned, and $100 is earned, then:
$100 x .05 = $5
is owned in tax. Because the person being taxed just received $100, we know that they have the ability to pay the $5. In other words, because the income is a liquid asset, the tax can be levied immediately without issue.
However, income is not always in the form of a liquid asset. For instance, if someone owns a stock worth $200 and the value of the stock rises to $210, that person has received $10 in value. This type of income is known as a Capital Gains because it is the “gain” in value of the asset’s “capital”, i.e. increase in the asset’s worth. Capital Gains are generally taxed at lower rates than Ordinary Income but can still create huge financial consequences for individuals with investments.
Because Capital Gains are just the increase in value of an asset, it is difficult to tax them on an ongoing basis. For instance, if a house is worth $500,000 and rises in value by $100,000 each year, do we tax the $100,000 at the end of each year? What would we do if the person being taxed doesn’t have the liquid assets to pay the Capital Gains Tax?
The solution is to only tax Capital Gains when the asset is being sold. So, if the house purchased at $500,000 is sold two years later for $700,000, the Capital Gain of $200,000 will be taxed at this point. If there is a 5% Capital Gains tax, then there is:
$200,000 x .05 = $10,000
in Capital Gains Tax owed.
One complexity with Capital Gains taxation is determining the “before” value of an asset, known in tax lingo as the tax basis. If a house is purchased for $400,000, its tax basis is $400,000 and any Capital Gains calculations will use $400,000 as the starting point for any increase in value. However, things work differently if an asset is gifted. Because there is no money changing hands with a gift of a Capital asset, we would have a liquidity issue if a tax was due upon the date of the gift. The solution here is to have no tax due upon the gift but for the asset to keep the same tax basis for the giftee as the giftor. For instance, if someone buys a house for $600,000 and then gifts the house to their daughter when the house is worth $700,000, the daughter will still have a tax basis of $600,000. When she later sells the house for $800,000 she will have $200,000 ($800,000 – $600,000) in Capital Gains. However, there is a different tax consequence for inheritances. If instead of gifting the house to their daughter, the person left the house to their daughter in their estate plan at their death, the daughter’s tax basis in the house will be the date-of-death value of the house. This is known as a stepped-up basis. In the example above, if the person buys a house for $600,000 and then dies when it is worth $700,000, leaving it to their daughter, when the daughter sells the house for $800,000 she will only have $100,000 ($800,000 – $700,000) in Capital Gains.
This tax difference between gifting and inheriting should always be considered when transferring houses or other Capital assets to children or irrevocable trusts. Although gifting a house may be advantageous for estate tax reduction, you may introduce substantial Capital Gains tax issues. It’s best to discuss any gifting strategy with your attorney to make sure you are not accidentally creating any negative tax consequences and to take a comprehensive approach to tax planning when making your estate plan.
Attorney Sean Downing is a senior 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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