Situation: Your client would like to transfer securities to family members and asks for your help.
Solution: Normally, you look for ways to discount the value of assets being gifted. Perhaps the silver lining of the recent
bear market is the built-in discount of security values. However, you must pay attention to cost basis and the ultimate use of the funds when deciding which securities to transfer. There are a variety of strategies for gifting assets, which will be explored in a later column. This column focuses on the tax issues that must be considered, regardless of the gifting strategy.
Each individual may transfer up to $13,000 to an unlimited number of individuals (recipients) each year, using the gift tax annual exclusion. A married couple can elect to split the gift and transfer $26,000 to each recipient. The annual exclusion is indexed for inflation, but changes only in $1,000 increments every year or two. Gifts in excess of this amount may be offset by the donor's lifetime exemption of $1 million. The recipient does not pay gift tax, but will pay income tax on income generated by the property in the future.
Gifted property retains the donor's cost basis unless the property has depreciated in value. Thus, a capital gain cannot be avoided by gifting the property. However, property can be gifted to a recipient in a lower tax bracket than the donor and the resulting tax liability upon sale would be decreased. Note that recipients under the age of 18 may be subject to the “kiddie tax,” which could offset the benefit of a reduced tax bracket.
A potential tax trap occurs when gifting property that has depreciated in value. The recipient's cost basis of the gifted property is the lesser of the market value on the date of gift or the donor's cost basis. Thus, property with a cost basis in excess of the current market value should not be gifted since the potential capital loss would be lost.
So, where do you start? First, find out if the recipient will hold or sell the gifted property. If the property will be sold, cash usually will be the best gift since none of the annual exclusion would be wasted on income taxes. For example, if your client gifts property worth $13,000 that has a cost basis of $10,000, the recipient would pay
capital gains tax on $3,000 when the property is sold. Thus, the recipient would net less than the annual exclusion. The donor's tax situation and cash flow requirements should be reviewed when determining which securities should be sold to generate the cash.
If the property will be held for investment by the recipient, the donor's cost basis is important to note since it will carry over to the recipient. Generally, you want to transfer property with high potential for appreciation and not a lot of built-in gain. Remember, do not transfer securities with a built-in loss. If the portfolio does not contain appreciated securities, it will probably be best to sell securities and gift cash. This way, the donor can take advantage of the capital loss.
Example: Your client plans to make an annual exclusion
gift to his adult daughter as part of his wealth transfer strategy. The client's portfolio includes stock of his employer, which was trading at $70 per share in 2006 and is currently trading for $45 per share. Your client purchased the stock for $35 per share. His portfolio also contains a mutual fund which has decreased in value by 10% since it was purchased last year and fixed-income securities with very little appreciation. Assuming his daughter will continue to hold the securities and the client is bullish on the employer stock, this may be the best asset to transfer. The mutual fund has a built-in loss that would be lost if the property was gifted. The fixed-income securities could be transferred if the appreciation potential exceeds that of the employer stock. Another consideration is whether the client has a concentration in the employer stock. Gifting a portion of a concentrated position carries additional risk. As you can see, security selection takes into consideration several aspects of the client's financial affairs.
