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The Pitfalls of Gifting Property Prior to Death

Death vs taxesIt’s important to understand the adverse tax consequences a recipient may face when gifting a large asset instead of having an heir wait to inherit them.

What if parents at retirement age, insist on transferring their assets under their children’s name to avoid probate when they pass away? If they have a primary home, an investment property, and savings accounts that total south of $1 million, are there really any tax advantages to making the changes?  I would caution against these drastic moves. These transfers have serious tax consequences, and most of them are not good.

Seniors frequently transfer assets to their children to be eligible for Medicaid, avoid probate, and eliminate estate and inheritance taxes. In New Jersey, until this year, residents were potentially subject to three taxes at death: the federal estate tax, the New Jersey inheritance tax, and the New Jersey estate tax. In 2016, and for the 15 years before that, the New Jersey estate tax was imposed on transfers to children, only if the total estate exceeded $675,000. In 2017, that amount was increased to $2 million. Beginning in 2018, the New Jersey estate tax was repealed.

There is also the inheritance tax in New Jersey, which wasn’t repealed. That tax is only imposed upon inheritances by individuals other than “Class A” beneficiaries. A spouse, child, grandchild, and parent all qualify as “Class A’ beneficiaries.” If the child in this example inherits those assets from his parents, there would be no New Jersey inheritance tax. The federal estate tax is not an issue, because it doesn’t apply until an estate exceeds $11.8 million (or $22.36 million for a couple).

There could adverse tax consequences in making transfers now rather than waiting for the parents’ deaths. The tax basis of any asset held until death is stepped-up to fair market value. Therefore, if the parents owned the property for many years, paid significantly less than it is worth today, and the building has been completely depreciated, then their tax basis is probably significantly lower than the fair market value.  However, if it were sold today, there would be a significant capital gains tax to be paid. That’s the difference between the sales proceeds received and the owners’ tax basis.

If parents gift the property to the children during their lifetimes, then the kids take the property with a carry-over basis—they’d have the same basis the parents had and would have the same capital gains tax due when sold. However, if the parents hold on to the investment property until their deaths, the children inherit the property with a stepped-up basis. The children could sell the property the next day and completely avoid any capital gains tax. Another option is to hold on to the property after the parents’ death and begin to depreciate the building again to decrease any taxes the kids would pay on any rental income. It works the same way for the parents’ primary residence.

Don’t allow parents to make these kinds of decisions, without speaking to an experienced estate planning attorney in your state. They will know the long and short-term tax consequences and help the family plan properly.

Reference: nj.com (April 10, 2018) “This estate planning mistake could mean huge tax bill”

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