February 2021 Newsletter – Tax Savings of Upstream Gifts to Parents

The Potential Tax Savings of
Upstream Gifts to Parents

Since the passage of the Tax Cuts and Jobs Act of 2017 combined with the mortality age shift, a new estate planning technique has become increasingly attractive. The technique, often called “Upstream Gifting”, involves making gifts of appreciated assets up the family tree to parents and/or grandparents. An important benefit of making upstream gifts is that at the older, donee, recipient’s death, the appreciated assets will receive a step-up in income tax basis. Those who receive the appreciated assets from the older generation should then be able to sell the assets with no capital gains tax due.

The key to the renewed interest in this tax strategy is the current federal estate and gift tax law, whereby you can give away $11.4 million of assets, while alive or after death. This exemption can be used to shield your estate from taxes upon death or during your lifetime to make tax-free gifts. However, as explained further below there is risk that the current federal estate and gift tax exemption and stepped-up in basis will be changed by the new federal administration.

There are other non-tax-saving opportunities that may exist with upstream gifting. This wealth transfer strategy allows younger generations to provide support to elders which can be for many non-tax reasons such as everyday living expenses, medical expenses, assisted living facilities, improved housing and vacations.

Tax Advantages

Traditionally, individuals focus on moving wealth downstream to younger generations. On the opposite extreme, one of the most common forms of upstream gifting strategies transfers assets to senior generations and who in return devises or bequeaths those assets back to the original donor, owner as part of the elder’s estate when they die. If these assets were sold by the original owner, he/ she may be responsible for capital gains tax. Gain on the sale of the property is generally equal to the difference between what the owner paid for the property and the value of the property when it is sold. However, if the original donor receives the assets back due to the death of the elder, donee, owner, its basis is adjusted to the fair market value of the property on the date of death of the senior, donee, owner. This tax basis adjustment may eliminate or substantially reduce any capital gains tax upon the eventual sale of the asset by the original donor owner.

For example, James and Elizabeth, a married couple, owns commercial real estate currently valued at $1 million with a cost basis of $200,000. If they decided to sell the real estate there would be a capital gains tax on the $800,000 gain.  James’ mother, now in her late 80s, is his only surviving parent. His mother has very few assets and will likely not make use of her entire federal estate tax exemption. James gifts the real estate to his mother with a carry-over basis of $200,000. However, when James mother dies and bequeaths the real estate to James, he will receive a step up in basis adjustment to the fair market value at her death. The step-up in basis would effectively wipe out the tax on the $800,000 gain.

The upstream transfer can be structured as a gift, as a sale to a carefully drafted trust or as part of a more complex strategy such as a grantor retained annuity trust. If the assets are highly appreciated, the tax benefit of the upstream gift can be dramatic, particularly if the family had wanted to sell the assets but felt constrained by the built-in capital gain.  There are no restrictions on what kind of appreciated assets can be used in upstream planning but certain assets are best avoided. Hard to value assets such as artwork and collectibles would require appraisals and their values are open to challenges by the IRS.

Risk of Upstream Gifting

It is important to note that the gifted assets will not receive basis step-up if the individual dies within one year of the gift and the assets revert back to the donor at the time. There are other risks when the assets are transferred from child to parent. The parent now owns the property. With ownership comes the legal right to sell the property, give the property away or pass it on to someone other than the original owner. The property could also be forfeited due to legal action or divided as part of a divorce settlement. The child should be very cautious when making the gift and firmly believe the parent will complete the transfer back to the child at his/her death. These risks can be mitigated if the child makes the gift to a trust for the parent’s benefit, rather than outright. However, the trust would need to be carefully drafted by legal professionals familiar with your specific tax and non-tax goals.

Finally, there is a risk the tax laws will change. Currently, the federal estate/gift tax exemption amount is set to increase every year until 2026, at which time it is scheduled to revert back to $5 million. However, President Biden has proposed to change the exemption amount to $3.5 million for estates, $1million for gifts and the elimination of the basis adjustment at death.  If the exemption amount is reduced as proposed after the upstream gift has been made, the elder donee, generation may have to pay federal estate taxes on the gifted assets after all and after the transfer back, the original donor will not have an adjusted basis. For this reason, upstream gifts are best suited for clients who have a true desire to provide for their parents, regardless of any tax benefits.

Conclusion

Using upstream gifts is a strategic approach to supporting senior family members. It avoids the need for elder family members to ask for assistance, it may provide income and estate tax advantages for your family, and it allows multiple generations to participate in wealth-transfer planning. The tax advantages referred to in this article are specific to federal estate tax. The upstream gift could result in additional state inheritance tax at death, depending on each individual’s state.

If you have any questions, feel free to contact either Joseph Pozzuolo or Jeffrey Pozzuolo to discuss your options.