By Garrett A. Eller.
The holidays are upon us causing many people to think about what gifts they want to give their loved ones. However, there are some gifts in life not worth giving because they can end up having some very harsh tax consequences.
Picture this: It’s Christmas Eve of 2009 in rural Oklahoma, a mother and father have thought about what they want to give their adult children. They recently drafted their estate plans and decided that they wanted to avoid probate proceedings. They hand each of their children a white envelope. The son opens his envelope and discovers he has been gifted the parent’s home. The daughter opens her envelope first and tears up learning that she has been gifted a piece of commercial property. Those tears were not tears of joy, but tears of knowing that her parents passing is inevitable someday. What these adult children and their mother and father do not realize is that they have created a new, potentially significant problem; significant tax consequences that will cost their children thousands of dollars in taxes.
Here is a brief tax lesson when it comes to income taxes and gifting property. When an individual purchases a piece of property, what they give for that property is called their basis. Basis is used in tax law to determine gains and losses.[1] For example, if you purchase a piece of property for $75,000 and sell it for $70,000, then you will have a $5,000 loss. Now if you bought that same property for $75,000 and sell it for $80,000 then you will have a $5,000 gain. Anytime you have a gain, then you are required to report that as income when filing your taxes for that year.[2]
You may be wondering why this matters for estate planning. Frankly, it matters significantly. Under our current tax laws, if you give a gift of property during your life, the person receiving the gift will take the gift with the exact same basis as you currently have in the property. Let’s go back to the example above, here we will focus only on the daughter. The land that was gifted to the daughter was actually purchased in the 1980’s for $30,000 when property values were lower than they were in 2009. So when that gift was given in 2009, the basis remained the same-- $30,000. Fast forward to 2019, the daughter decides to sell that property for $60,000. Now, the gain from the sale of the property is $30,000 and the daughter is required to report that income on her 2019 tax return.
Tax consequences like this can be avoided through careful planning, just DON’T GIFT IT! Allow your property to be inherited by those that you want to give it to you. Under our current tax laws, if a piece of property is inherited, the person taking the property through inheritance will take the property with a stepped-up basis. A stepped-up basis means that the person inheriting will have a basis equal to the fair market value of the property on the date of death. So in the example above, if the parents had passed away in 2018 when the fair market value of the commercial property was $60,000, then the daughter would have inherited the property and her basis would have been $60,000. Therefore, the sale that occurred in 2019 of the same property for $60,000 would have occurred and she would have had no gain or loss and therefore would have no income tax consequences.
If you or your loved one’s intentions are to make an estate plan that is easy, simple, and avoids the hassle of probate, there are many estate planning options that do not have tax consequences. For example, the State of Oklahoma allows for transfer on death deeds. These instruments allow for the owner of real property to sign a deed that is very similar to a will and file it in the County Clerk’s records. This instrument will transfer the property to the recipient named upon filing of a beneficiary’s affidavit.[3]
An estate plan, however, should not only manage your land or other real property, but should take into account all of your assets, including bank accounts, vehicles, retirement, and personal belongings. The number one method of estate planning is creating a Living Trust. A trust is an entity that is allowed to hold title to property. The trust is a legally binding document that details what is to happen to your property after death or even during life if you become incapacitated. And the best part of a Living Trust is that since it is its’ own entity, it doesn’t die and therefore your loved one’s will be able to avoid the long and expense probate process.
One question I get frequently is, “What if my parents have already added me to their deed or given me property.” The good news is it can still be corrected, however, making the correction sooner rather than later is best. As long as the person that gifted the property is still alive, then the correction can be made. Deeding the property back to the original owner is one step that can be taken, followed up by executing a proper estate plan. Before making or accepting a gift such as this, discuss the matter with your Attorney and your financial advisor or accountant.
[1] Basis in property can fluctuate. The amount you spend on improvements to a property will increase your basis in that property when it comes time to calculate gains and losses.
[2] Your gain may be taxed at different rates depending on how long you owned the property. Any property owned by someone for longer than twelve months well have the benefit of having their gain taxed at the capital gains rate rather than the individual rate.
[3] Oklahoma’s current law requires that the beneficiary’s affidavit must be filed within nine (9) months of the date of death. Failure to meet this deadline will void the transfer on death deed and the property must be probated.