Understanding the Tax Consequences of Gifts

Posted by Harvey L. CoxAug 18, 20210 Comments

Example:  Janet is diagnosed with terminal cancer.  She has three grown children.  Janet heard that her children would likely spend thousands of dollars to probate her estate after her death.  Since her only real asset is her family home, she is concerned that they will spend too much on probate to get the house in their names.  Janet also heard that she can help her children avoid probate by deeding the home to them while she is still alive.  Janet hires a lawyer to prepare a deed transferring her home to her children while she is still alive.

Janet is fortunate that none of her children were going through a divorce, dealing with tax liens, or dealing with lawsuits for unpaid debts before her death.  If any of them had been dealing with those issues, Janet's home would have been subject to claims for those tax liens, lawsuits, or ex-spouses of the children.

But, after Janet had died, her children discovered why it is crucial to consider the tax consequences of a gift.  When Janet's children sold her home after her death, they found that their basis (the cost for determining taxable gain) was Janet's cost of the house when she purchased it 30 years ago.  That original price was $20,000. Janet's children were able to sell the home for $180,000.  Since their basis in the house was only $20,000, the children had a taxable gain of $160,000.  Using the top capital gains tax rate of 20%, the children owe $32,000 in capital gains tax.

If Janet had kept the property in her name or transferred it into a Living Trust, her children would have inherited the property with a step-up in the basis. The step-up in the basis means the children's basis for tax purposes would have been the property's fair market value at the time of Janet's death.  Assuming the fair market value is the $180,000 for which they sold the home after Janet's death, no capital gains tax would have been due on the sale. Janet's gift to her children in an attempt to avoid the cost of probate costs her children $32,000.  That is much more than probate would have cost her family.

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