Is it a good idea for income and estate tax purposes to deed property to a child while I am alive?

Consider the following as a test case:

I have one child to whom I intend to leave all my assets. I am thinking about deeding a rental property to my child while I am alive to reduce the amount of assets I own for estate tax purposes. Is this a good idea? Or would it be better to leave the property to my child at death through my Will so my child can get a stepped-up income tax basis at my death?

The answer depends on the following:

1. How likely is the parent to owe ESTATE (death) taxes at death?

2. How important are the INCOME tax attributes of the real estate?

Framework for ESTATE (death) tax planning:

1. The estate (death) tax is a one-time tax assessed at death and is based on your NET WORTH as of date of death.

2. Under the 2020 rules, the tax is generally a 40% tax on each dollar of net worth of the Decedent that exceeds $11.5 million (rounded).

3. Example: Uncle Warbucks dies in 2020 and is worth $21.5 million at death. He has $10 million of net worth exposed to estate taxes (21.5 minus 11.5). Uncle Warbucks’ executor will need to pay the IRS $4 million ($10 million x 40%) prior to making distributions to his child.

Framework for INCOME tax planning – gifts received while parent is ALIVE:

1. Children receiving gifts take the same “tax basis” as the person who gifted the property to them. Internal Revenue Code Section (IRC) 1015.

2. Example: Uncle Warbucks owns a rental property that is worth $1 million but after many years of depreciation only has an income tax basis of $200,000. If Uncle Warbucks gifts the property to Annie while Uncle Warbucks is alive then Annie’s income tax basis in the property is the same as Uncle Warbucks – $200,000. If Annie sells the real estate for $1,000,000 then her taxable gain on the property is $800,000 ($1,000,000 sales price minus $200,000 income tax basis). For simplification we are ignoring depreciation recapture rates and Section 1031 exchanges.

Framework for INCOME tax planning – gifts AFTER DEATH via parent’s will:

1. Children receiving gifts from a Decedent receive a “stepped up” income tax basis when inheriting property. It as if the child purchased the inherited asset from the Decedent for the asset’s fair market value on the day the Decedent died. Internal Revenue Code Section (IRC) 1014.

2. Example: Assume Uncle Warbucks has a rental property worth $1,000,000 but after many years of depreciation the property only has an income tax basis of $200,000. In this case Uncle Warbucks leaves the property to Annie through his Will. Upon Uncle Warbucks’ death, Annie’s income tax basis in the property received via inheritance is $1,000,000 because IRC 1014 treats her as though she had purchased the property from Uncle Warbucks for the fair market value of the property on his date of death. If Annie sells the property for $1,000,000 she will have no taxable gain ($1,000,000 sales price minus $1,000,000 income tax basis).

What to Make of These Rules?

In this case, the goals of avoiding estate taxes for Uncle Warbucks’ estate AND minimizing income taxes for Annie are in conflict.

If we are confident that Uncle Warbucks will owe estate (death) taxes then gifting property out of his estate during his lifetime is typically the more important consideration because the estate tax rate is 40% compared to a maximum capital gain tax rate of 23.8%. Note: the long-term capital gain tax rate for most taxpayers is 15% but if you are in the highest income tax bracket and the net investment income surtax applies to you then your long term capital gain tax rate rises to 23.8%.

Some estate planners would recommend using a structure such as a Family Limited Partnership so that Uncle Warbucks could (a) transfer economic ownership of the property to Annie during his lifetime to reduce his estate tax exposure while (b) maintaining operational control of the property during his lifetime and (c) getting a gift tax valuation discount on the economic interest transferred to Annie.

If we do not think Uncle Warbucks is likely to owe estate (death) taxes then we typically want to delay transferring assets to children until death so that any unrealized capital gains in the property disappear at death through the stepped up income tax basis rules. In this case, the benefit to Annie is that she inherits property without a built-in capital gain. For properties that have appreciated substantially during the owner’s life this could result in substantial income tax savings for children inheriting assets.

A complication to this question is that the estate tax thresholds are likely to change in the future. First, the estate (death) tax is scheduled to apply to Decedents with a net worth of approximately $6 million starting on January 1, 2026 down from the current $11.5 million (rounded) level for 2020.

Furthermore, as of January 2020, some presidential candidates are proposing to cause the estate tax to apply to individuals dying with $3.5 million in net worth while also increasing the estate tax rate from 40% to 50%, 55% or 77% depending on net worth (CNBC article, January 2019).

Optimizing estate and income tax planning can be complicated.

If you would like help evaluating whether your estate plan has a good combination of both estate and income tax planning best suited to your situation, please feel free to give our law firm a call to schedule a meeting!

By: Chris Ha