How to Utilize Upstream Gifting
Upstream Gifting: Key Points
Younger generations can gift assets to elderly relatives to assist them with their living expenses, while also decreasing the value of their estate and minimizing income taxes paid.
Gifting appreciated assets to older family members with low estate valuations can result in a potential step-up in basis on the assets received upon that elderly family member’s passing.
It’s important to have a high degree of trust or to incorporate trust planning into an upstream gifting strategy to ensure assets are utilized and maintained according to the donor’s wishes.
Upstream Gifting involves the transfer of financial assets from younger to older generations. These gifts are most commonly cash or checks but can also be shares of appreciated stocks, Exchange Traded Funds (ETFs), or even real estate.
When we think of transferring assets between generations, we tend to think of parents giving assets to their children, but that’s not always the case. Sometimes younger generations transfer what is called, “upstream” for two reasons:
1. To provide financial assistance
2. To achieve tax savings
Helping Elderly Family with Upstream Gifting
Recent studies have indicated that retirees are increasingly requiring external assistance – in some cases, from their younger children and relatives.
According to a 2020 Employee Benefit Research Institute (EBRI) study, 9 in 10 retirees and those approaching retirement consider Social Security a major source of income, while 75% mentioned employment income as the remaining source.
For younger generations who may have been more successful financially, almost 1 in 5 millennials and GenXers studied by TD Ameritrade say they are currently helping or expect to help supplement an older family member’s expenses during retirement. This is the most obvious reason to gift upstream.
Income Tax Benefits of Upstream Gifting
Although some choose to gift cash or checks to older family members, there are income tax benefits in transferring appreciated assets to those in lower tax brackets.
When the transferring party is younger and pays much higher income tax rates than their elderly parents or relatives, transferring highly appreciated assets to the older party in a lower income bracket provides two opportunities:
1. The recipient could sell the assets at lower capital gains tax rates.
2. If the recipient doesn’t need the assets for their living expenses, they could hold them until they pass, wherein the donor would stand to inherit those assets back. The donor’s inherited securities would also receive a step-up in basis as of the date of the recipient’s passing (so long as those securities were held for at least one year after transfer).
This can be confusing, so let’s look at the following scenario:
Josh, 65, owns an investment real estate property valued at $1,000,000, which he originally purchased for $500,000. John decides to gift this property to his father, Bob. Josh is in the 37% federal income tax bracket for the forseeable future.
Bob is 90. He doesn’t need the home but agrees to hold it for the remainder of his lifetime.
Bob has a small estate and has spent most of his assets throughout his life. He passes away at 95 and lists Josh as the primary beneficiary of the donated property (now valued at $1,200,000) in his trust. Josh inherits the property since Bob held it for at least 1 year.
The property now has an updated cost basis of $1,200,000 as of the date of Bob’s passing. Josh decides to sell the property shortly thereafter for $1,200,000.
By using the upstream gifting strategy, he avoids paying long-term capital gains taxes of $166,600 ($700,000*23.8% LTCG Tax = $166,600) on the sale.
What Are the Tax Implications of Gifting?
When discussing upstream gifting or gifting of any kind, consider the implication of whether a gift tax may be due on the transfer of assets. Individuals are allotted a “lifetime exemption” amount. They can utilize this exemption to make gifts to parties throughout their life or after they pass. As of 2020, the “lifetime exemption” amount is $11,580,000. Gifts or transfers made in excess of this limit are taxed at a 40% gift tax rate.
Fortunately, our tax code has also allotted an “annual exclusion” gift amount of $15,000 per individual, which doesn’t count against your lifetime exemption. In evaluating the amount and strategy for upstream appreciated security gifts, it’s key to ensure any gifts are within the annual exclusion limits so the donating party doesn’t risk running through their lifetime exemption with their own estate value.
Since laws are always changing, it’s important to stay up-to-date on any laws or legislation related to the step-up in cost basis for inherited assets. For example, current tax proposals from the Biden administration and many Democratic candidates have called for the elimination of this provision, which could impact the viability of strategies such as this.
Potential Downsides of Upstream Gifting and Estate Planning Solutions
Though the tax-saving opportunities in some situations may be immense, making a completed gift can present a potential downside. Completed gifts at their base imply ownership. This in turn affords the recipient the legal right to sell the property and spend it; give it away, or pass it on to someone other than the original owner. Property could also be forfeited due to legal action against elderly relatives or divided due to divorce. In situations like this, it’s of the utmost importance to have a high degree of trust in the individual receiving the gifts. There are options for donors who may have less confidence that their relatives will follow through with their wishes.
Instead of gifting assets directly to relatives, donors could instead transfer assets into a trust. In this trust, they could stipulate instructions to benefit the elderly relatives but limit their control over how these assets are spent. The donating party would grant the elderly relative a general power of appointment over trust assets to ensure they’re held for the donating party upon the elderly relative’s passing. This preserves the ability to receive a potential step-up in basis if assets are not sold or spent. It also opens the opportunity for the trust to be generation-skipping tax-exempt. This also helps avoid potential estate taxes at the donor’s passing.
Recap
Transferring assets to elderly family members may not seem to be a common practice, though there are significant opportunities to do so in the form of appreciated assets. Instead of gifting cash, gifting appreciated securities to family members in a lower tax bracket could result in fewer taxes being paid. If older family members don’t need the assets and have a smaller estate than their kin, they can hold the assets until they pass. Upon their passing, the donating party could then receive those assets back with a step-up in basis, resulting in reduced income and estate tax payments.
We, at Capstone in Downers Grove, IL are here to evaluate if strategies such as this make sense in your financial situation. Please give us a call if you have any questions, or consult your local attorney for more information.
Disclosures:
This article is not a substitute for personalized advice from Capstone and nothing contained in this presentation is intended to constitute legal, tax, accounting, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. This article is current only as of the date on which it was sent. The statements and opinions expressed are, however, subject to change without notice based on market and other conditions and may differ from opinions expressed by other businesses and activities of Capstone. Descriptions of Capstone’s process and strategies are based on general practice, and we may make exceptions in specific cases. A copy of our current written disclosure statement discussing our advisory services and fees is available for your review upon request.