How I Help Families Avoid Gift Tax Disaster and Protect the Step Up in Basis

I was speaking with a woman following one of my many educational events this past month. This woman was from Franklin, Tennessee and had told me that her husband passed away a few years ago. She went on to tell me that her and her husband had a trust put in place about 15 years ago, and when her husband passed away, everything was so easy and she really didn’t have to do anything. However, now that it has been several years since her husband passed away, she wanted to review her current trust and see if she needed to update her existing estate plan.

In addition, this woman had a question about her a vacation home that she owned in Chattanooga. She explained to me that she bought this home about 50 years ago for $25,000 and that she just couldn’t take care of it anymore. This woman wanted to give this home away to her children within the next year or two.

I explained to this woman that I would not recommend that she give this vacation home to her children. I continued to explain to this woman that if she gives away this home, it can have severe tax consequences for her and her children. This woman explained to me that the vacation home had appreciated significantly over the years, and was now worth approximately $500,000.

I discussed with this woman that there are two significant tax consequences if she gave away this home to her children. First, I explained that her children would lose the step up in tax basis. I explained that tax basis is the amount the IRS considered when it comes to the sale of an asset. I continued to discuss with this woman that your tax basis is what you paid for the home, in this case, $25,000. Therefore, if you sold the home today, you would owe capital gains tax on the $475,000 gain, which is approximately $71,250 in taxes. In addition, if you gave away this home to your children, they would inherit your tax basis (what is called the carry over basis). Therefore, if your children chose to sell the home in a few years, they would also owe capital gains tax on the difference between the current value of the home and what you paid for the home.

However, I also discussed with this woman that if you put this home in the name of your trust and the home transfers at your death to your three children, then your children will experience what is called a step-up in tax basis. What this means is that your children’s tax basis would be the value of the home on the date that they acquired it. For instance, if you died today, your children’s tax basis would be $475,000 and not $25,000. Therefore, if they chose to sell the home in a few years, your children would only owe capital gains taxes on the difference in value between the date they inherited the home and the value of the home on the date that they sell (a very significant difference and significant tax savings).

In addition, I also discussed with this woman that giving assets away to your children can have a significant effect on estate taxes that may or may not be due at your death. I explained that the IRS lets you give away up to $14,000 to whomever you want each year during your lifetime. However, if you give away more than $14,000 in a year, then you have made a taxable gift that needs to be reported to the IRS. Therefore, I explained to this woman with your house, if you gave this to your children, the IRS would consider you to have made a taxable gift in the amount of $486,000. In addition, this would result in your $5.4 million exemption from the federal estate taxes at your death to be reduced to $4.914 million. Therefore, I explained to this woman that if you die owning more than $4.914 million in assets, then your heirs will have to pay estate tax on the amount over $4.914 million at the tax rate of 40%.

If you have questions about estate planning, irrevocable and revocable living trusts, and avoiding nursing home expenses, please reach out to me before you go see any other lawyer or make any other decision on your estate planning so I can send you our free legal report “Estate Planning in Tennessee,” which goes over all the common questions about probate in Tennessee, Medicaid, nursing home expenses, and protecting your assets for your loved ones.

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