Inheritance or Lifetime Gift?

Even though the nominal federal gift and estate rates are the same, it generally costs more money (after taxes) to transfer a particular amount upon death than by making a lifetime gift. This is because the federal estate tax is levied on the entirety of the estate. Tax is paid first on everything included in the estate. In contrast, the gift tax is levied more in the form of a retail sales tax: the appropriate percentage of tax is applied to the amount of the gift. This makes for a lower effective rate for the gift tax. As such, a lifetime gift can be a more "tax-efficient" way to transfer one's wealth.

As a general estate tax rule, it has typically been thought better to make lifetime gifts of property that's expected to appreciate significantly in the future, so that the increase in value would occur while someone else (presumably of a younger generation) owns it. This delays (and, under some circumstances, possibly even avoids completely) estate taxation for many years. Conversely, it's traditionally been deemed better to wait until the time of death to give property that has already appreciated significantly in price, such as long-term stock holdings or a home that's gone up in value substantially.

To see why this makes sense, it's first important to understand the tax principle behind the conventional wisdom. The significance of whether the would-be gift is property that has "already appreciated" or "expected to appreciate" lies in the manner in which the beneficiary receiving the property must compute his or her profit (or capital gain) for income tax purposes, if and when the property is ever sold. The key concept, therefore, is the property's tax basis.

Basis can generally be explained as follows: when property is sold, the seller is taxed on any gain – the difference between the sale price received and the seller's tax basis in the property. Usually, the tax basis is the amount that was originally paid for the property, plus the costs of any significant additions, upgrades, or improvements that have been made (such improvements would obviously apply to real estate investments, not to financial assets). Therefore, the higher the basis that can be claimed at the time of a property's sale, the lower the amount of gains that will be subject to income tax.

As an example, let's consider an asset with a basis that is simply the price the owner paid for it. This could be long-held stock in a solid company. If the owner decides to give the stock to his son, what would be the son's tax basis if he receives it by a lifetime gift or as an inheritance? There's a substantial difference between the two possibilities. For instance, property given by lifetime gift will take the same tax basis in the recipient's hands as the donor had (which will generally be the price that the donor originally paid for it). This is known as a "carry-over" basis.

However, property received by inheritance does not keep the basis that it had in the donor's hands; it receives a new "stepped-up" basis for tax purposes. This new basis, which the recipient must use to calculate taxable gains if he or she sells the property, makes a "step up" to the fair market value of the property on the date of the estate owner's death. Therefore, if the son receives the stock by inheritance and immediately sells it at its fair market value, there will be little or no taxable gain. As such, many years of appreciation in value could totally escape capital gains taxation.

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