Taxation of Lifetime Gifts vs. Transfers at Death

From a tax planning perspective, should a client hold property until death or transfer it during his or her lifetime?  The answer depends on several factors, including the transfer tax rate and the taxpayer’s long-term capital gain rate.  Both of these variables were affected by the American Taxpayer Relief Act of 2012, which made two significant rate changes:

• The Act raised the top rate for capital gains to 20 percent for taxpayers with income in excess of the high-earner threshold ($400,000 for single filers, $450,000 for joint filers, and $425,000 for heads of households); and
• The Act raised the maximum federal estate and gift tax rate to 40 percent (up from 35 percent under prior law).

Each of these new rates must be taken into account to decide between a lifetime gift and a transfer at death. Before making a lifetime gift, the taxpayer must weigh the tax exclusive nature of the federal gift tax against the income tax consequences resulting from the loss of basis step-up.

Transfer Tax Considerations: Tax Exclusive vs. Tax Inclusive Taxation

The federal transfer tax system taxes the transfer of wealth during one’s lifetime (the gift tax) and the transfer of property at death (the estate tax).  A third transfer tax—the federal generation-skipping transfer (GST) tax—applies to transfers to recipients that are removed by more than one generation from the transferor.

The estate tax is tax inclusive, meaning that the funds used to pay the estate tax are themselves subject to the tax. In other words, the estate tax is imposed on the entire value of the estate, including assets that will ultimately pass to the federal government in the form of estate taxes.[1]

In contrast, the gift tax and is calculated based on the value received by the recipient of the transferred property.  This means that the amount paid by the transferor in connection with the transfer is not subject to the tax.[2]  Because of this, the gift tax is said to be tax exclusive.

This distinction has important consequences. Because taxes on lifetime gifts are tax exclusive, they are less expensive from a transfer tax standpoint than transfers that take place at death.

To illustrate, assume that Biden wants to transfer $1 million in cash to his daughter when the estate tax rate is 45 percent.  Let’s also assume for simplicity that Biden has no unified credit/exclusion amount available.

If Biden transfers the cash during his lifetime, his gift tax will be based on the amount actually received by his daughter.  This creates a circular computation since the amount of the gift isn’t known until the amount of the tax is determined. However, this computation can be expressed in algebraic terms: The taxable transfer will equal the amount of the transfer ($1,000,000) divided by 1 + the tax rate (1.45). In this case, the taxable transfer would be $689,655. Applying the 45 percent tax rate to this amount will result in a gift tax of $310,345.

On the other hand, if Biden holds the cash until his death (assuming no changes in value), the estate tax will apply to the entire amount included in his estate ($1,000,000).  As a result, he will owe $450,000 in estate taxes – $139,655 more than Biden would have paid if he had given the cash away during his lifetime. In other words, all else being equal, a transfer at death will result $139,655 more transfer taxes than a lifetime transfer.

Income Tax Considerations: Loss of Basis Step-Up vs. Transfer Tax Savings

Of course, transfer taxes are only part of the equation. If the transfer includes appreciated property, the income tax rules must also be taken into account.  Specifically, the taxpayer should discount the transfer tax savings by any appreciation that would be preserved in the property due to the loss of stepped-up basis.

Under the income tax basis rules (IRC § 1014(b)(9)), property that is held until death qualifies for a basis step-up, effectively erasing any appreciation. This basis step-up is forfeited if the property is transferred during lifetime, in which case the recipient will take the transferor’s basis in the property. As a result, all appreciation in the property will be preserved and eventually taxed when the recipient disposes of the property.

Whether the transfer tax savings will outweigh the loss of the basis step-up depends on the tax rates involved. In the current environment, a built-in 15 percent or 20 percent capital gains tax could erase any transfer tax savings that may result from a lifetime gift.

In the example above, assume that, instead of cash, Biden wants to transfer $1 million in property to his daughter.  Assume that the property has a $200,000 cost basis and that Biden’s daughter is subject to a 20 percent capital gains rate. In that situation, the income tax cost of the lifetime transfer would be $160,000 due to the $800,000 of deferred capital gain built into the transfer. The additional income tax cost of a lifetime gift exceeds the $139,655 transfer tax savings.

In other words, number crunching is required to determine the tax consequences of holding property until death. Making the transfer at death will make sense if the capital gain built into the property exceeds the transfer tax saving attributable to the tax exclusive nature of the gift tax.  This requires a relatively low transfer tax rate and a relatively high built-in capital gain. If, on the other hand, the transfer tax savings inherent in a lifetime gift exceed the built-in capital gain, the taxpayer should consider a lifetime gift.