Upstream gifting can help you financially support senior family members. Such gifts may also provide you with substantial tax savings.

Many families provide financial assistance to parents and grandparents. But simply writing checks or moving mom or grandpa into the family home may not be best way to cover costs and could raise some tax issues.

The recent tax reform combined with demographic shifts and market forces are now creating opportunities for a type of planning known as upstream gifting. This strategy provides financial support to senior family members while also creating substantial tax savings.

Lending a Hand

Families provide support to elder family members for many reasons. Some seek to supplement their parents’ and grandparents’ lifestyle in retirement by paying for vacations, entertainment, improved housing, and automobiles. Others may tend to more basic needs, such as everyday living expenses, medical expenses, assisted living facilities, or possibly building in-law suite additions to their homes.

Tax-saving opportunities may exist with upstream gifting. This wealth transfer strategy allows younger generations to provide support to elders. It can provide particularly significant capital gains tax advantages when a family owns highly appreciated assets and their parents or grandparents do not expect to have an estate large enough to trigger federal estate taxes.

The estate tax exemption took a substantial leap in 2013 and again, though possibly temporarily, in 2017. In 2019 an individual may pass on $11.4 million free of federal estate taxes and a married couple may pass on $22.8 million[1].

Tax Advantages of Upstream Gifting - A Primer

Upstream gifting is a type of wealth transfer planning. Traditionally, people focus on moving wealth downstream to younger generations. One of the most common forms of upstream gifting strategies transfers assets to senior generations and returns those assets to the initial owner as part of the elder’s estate when they die. It provides an opportunity to financially support elder family members while cutting the capital gains tax bill on the assets after they are returned to and sold by the initial owner.

When certain property is sold, the owner may be subject to a capital gains tax.[2] Gain in the property is generally equal to the difference between what the owner paid for the property, referred to as its basis, and the value of the property when it is sold.[3]

*Capital gain income = sales price – cost basis.

There is a unique advantage in the tax code when property is transferred to another individual due to death. When an individual receives property due to the death of the owner, its basis may be adjusted to the fair market value of the property on the date of death. This adjustment may eliminate or substantially reduce any capital gains taxes upon the eventual sale of the asset.[4]

Example 1: Upstream Gifting

Upstream gifting opportunities may exist when a family owns highly appreciated assets and their parents or grandparents do not expect to have an estate large enough to trigger federal estate taxes.

Robert and Susan, a married couple, own commercial real estate currently valued at $2 million with a cost basis of $200,000. Robert’s mother, now in her late 80s, is his only surviving parent. His mother has very few assets, and Robert and Susan desire to financially support her.

Robert gifts the real estate to his mother, and she uses income from the property to take a few vacations, pay some medical expenses, and eventually pay for quality care in a skilled nursing facility. At the time of the gift, Robert’s basis of $200,000 carries over to his mother. But when Robert’s mother passes away and leaves her real estate to Robert, he will receive a step-up in basis to the fair market value at her death.[5]

No estate tax would be due because his mother’s estate is below the estate tax exemption level. Assuming the real estate did not appreciate any further after the gift, Robert’s basis would now be $2 million. Robert and Susan decide to sell the real estate. The step-up in basis would effectively wipe out the tax on $1.8 million of gain ($2 million- $200,000) and create a potential tax savings of $360,000 (20% capital gain tax rate x $1.8 million gain).

Mitigating Potential Pitfalls

While the tax-saving opportunity may be significant, there are a number of potential pitfalls to simply gifting ownership of property to parents, grandparents, or other elders. 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 against the elders or divided as part of a divorce settlement.

One way to address these concerns would be to gift the property to a trust instead of directly to the parents or grandparents. The trust would need to be carefully drafted by legal professionals familiar with your specific tax and non-tax goals. The strategy would involve transferring appreciated property to a trust that is designed to accomplish the following:

  • The trust would own the appreciated property and provide income for the benefit of senior family members.
  • The transfer of appreciated property to the trust would not be considered a sale that triggers capital gain taxes.
  • The trust would provide a level of creditor protection for the property it holds.
  • Upon the death of the senior family member(s), the property would be included in their estate, with no estate taxes due based on the size of their overall estate.
  • The trust would limit the individuals who may receive the property after the death of the senior family member(s).
  • When the property is passed back to the initial owners, they would receive a step-up in basis to the fair market value of the property[6], thereby reducing or eliminating capital gain taxes due upon the sale of the property.

*The trust design discussed above requires knowledge of complex legal and tax rules that are beyond the scope of this article, and should be discussed with professional legal and tax advisors.

Lifetime Gift Considerations

It is important to consider whether a gift tax may apply to the specific type of support provided. There is a 40% federal tax on gifts in excess of the annual gift exclusion of $15,000 per individual in 2019[7] and lifetime exemption of $11.4 million (individual)/$22.8 million (married) in 2018.[8] The tax code provides a number of different exceptions.

For example, 100% of payments made to pay for another person’s medical expenses may be excluded from the gift tax if the payments are made directly to the provider.[9] On the other hand, there are a number of ways to unexpectedly trigger a gift tax. For example, the IRS may attempt to levy a gift tax for allowing someone to reside in a residence you own rent-free.[10]

Three forces are now converging—the significant increase in the estate tax exemption; the rise in the number of new wealth creators who are seeking to support elders; and the strong appreciation of many assets. Taken together, they are putting more focus on upstream gifting. These strategies can provide families with a means to provide support to parents and grandparents and a substantial tax savings for themselves.

A strategic approach to supporting senior family members

  • Avoids the need for elder family members to ask for assistance.
  • May provide tax advantages for your family.
  • Allows multiple generations to participate in the wealth-transfer process.

For more information, please contact your PNC advisor.