A previous article appearing in Planning Matters discussed the use of lifetime gifts to reduce New Jersey estate taxes. The article pointed out that although there can be advantages to lifetime gifts, there are situations where embarking on a lifetime gifting program in New Jersey is ill-advised. This article will address some of those circumstances where lifetime gifts will not result in a tax benefit.
The starting point for this discussion is the income tax concept of basis. Basis is relevant for determining the gain realized from the sale or other disposition of property for capital gain tax purposes.[1] In general, the basis of property is the cost of the property to the taxpayer.[2] There are special rules with respect to basis where property is acquired by lifetime gift and where property is acquired from a decedent.
In the case of property acquired from a decedent’s estate, Section 1014 provides the general rule that the basis of property in the hands of a beneficiary is the fair market value of the property at the date of the decedent’s death. This concept is oftentimes referred to as “stepped-up basis” because the taxpayer receives a free step-up in basis to the value of the property at the time of the decedent’s death without being subjected to the payment of a capital gain tax.[3]
In the case of property acquired by lifetime gift, Section 1015 provides the general rule that the basis of property in the hands of the recipient of the gift is the same as the donor’s basis in the property. This concept is generally referred to as “carryover basis” because the basis of property in the hands of the recipient of a gift is carried over from the donor of the gift.[4]
The foregoing discussion of basis introduces the concepts of stepped-up basis and carryover basis, which are critical to understanding why lifetime gifts to avoid New Jersey estate tax are not always tax efficient in the larger sense. To illustrate the point, note the following examples:
Example 1. Assume a New Jersey resident decedent dies in 2017 with an estate of $3-million. In this case, the total New Jersey estate tax is $82,400, and the basis of the estate property in the hands of the beneficiary is $3-million, as a result of the step-up in basis on death provided by Section 1014.
Example 2. Assume a New Jersey resident has an estate of $3-million, of which $2-million is cash and $1-million is a house having a basis of $100,000, and before death in 2017, the decedent makes a lifetime gift of the cash, leaving an estate of $1-million consisting of the house. In this case there is no New Jersey estate tax because the estate is under the $2-million threshold, and there is an estate tax savings of $82,400. The basis of the cash gift in the hands of the recipient is $2-million, the same as in the hands of the decedent, due to the carryover basis for lifetime gifts provided by Section 1015, and the basis of the beneficiary in the house is $1-million, due to the step-up in basis on death provided by Section 1014.
Example 3. Now, assume a New Jersey resident has an estate of $3-million, of which $2-million is a house having a basis of $100,000 and $1-million is cash, and before death in 2017, the decedent makes a lifetime gift of the house, leaving an estate of $1-million consisting of the cash. In this case there is no New Jersey estate tax because the estate is under the $2-million threshold, and there is an estate tax savings of $82,400. However, with respect to the lifetime gift of the house, the carryover basis rule applies and if the recipient of the gift of the house were to sell it, the basis in the house for capital gain purposes is $100,000, the same as the basis in the hands of the donor. The result is that a capital gain would be realized in the amount of $1.9-million, which at federal capital gain rates could be as high as 23.6% and at New Jersey capital gain tax rates could be as high as 8.97%, and the recipient of the lifetime gift of the house could be exposed to federal and New Jersey capital gain taxes upon its sale as high as $618,830!
In the last example, one would certainly prefer to pay a New Jersey estate tax of $82,400 and receive a step-up in basis at death, over the capital gain tax of $618,830 that resulted from the lifetime gift of the house. Had the house been held in the estate at the time of death, rather than been the subject of a lifetime gift, the capital gain tax could have been avoided entirely.
As Example 3 vividly demonstrates, it is important to carefully consider all of the relevant tax aspects before implementing a lifetime gifting program to reduce New Jersey estate taxes. Otherwise, the consequences could be severe.
[1] Section 1001(a) of the Internal Revenue Code of 1986, as amended (hereinafter the “Code”), provides that gain from the sale or other disposition of property is the excess of the amount realized over the adjusted basis, and loss from the sale or other disposition is the amount of the adjusted basis over the amount realized. For purposes of this article, a reference to “Section ____” is a reference to a specific section of the Code.
[2] See Section 1012. Although generally basis is understood to be the cost of property, adjustments to basis are allowed in certain circumstances. The rules concerning adjustments to basis, addressed in Code Section 1011 and others, are outside the scope of this article.
[3] There are exceptions to this rule, as there are for any number of provisions of the Code. For example, Section 1014(e) contains the rule that where a donor transfers property to a decedent within one year prior to the decedent’s death, and upon the decedent’s death the property is transferred back to the original donor, the basis of the property received by the donor from the decedent’s estate is the basis immediately prior to the decedent’s death. In other words, there is no step-up in basis allowed under these circumstances. The rule was adopted to prevent a tax-free basis step-up through a deathbed gifting program designed to avoid the imposition of a capital gain tax.
[4] As one might expect, there are exceptions to the general rule of carryover basis for lifetime gifts as well. For example, where the fair market value of property on the date of a gift is less than the donor’s basis, the general rule is that the recipient’s basis for purposes of determining loss is the fair market value of the property. See Section 1015(a).