Property owners have several decisions to make when it comes to estate planning, and one of those is whether to give property to heirs before or after death. Montana State University Extension has released a new MontGuide that gives information on how to approach that choice.
According to university educators across Montana, it is important to consider the income tax consequences of the timing of gifts to family members because the state eliminated the state inheritance tax in 2001. Now the federal estate tax only impacts individuals with estate values at more than $12.06 million or married couples with more than $24.12 million.
When an individual sells property, not all of the proceeds are taxable, said Marsha Goetting, MSU Extension family economics specialist and MontGuide co-author. She added when income is calculated, a person is only taxed on the difference between their “basis” in the property and its sale price. As a general rule, basis is the amount paid to buy an asset, like a house, car, equipment or stocks. The basis of some assets, such as equipment in a business, can depreciate. When this type of an asset sells, the tax liability is calculated based on the sale price received minus the depreciated basis.
In deciding whether to make a gift before death or in a will, revocable trust or testamentary trust, an individual should understand the difference between a “stepped-up” basis and a “carry-over” basis, says E. Edwin Eck, professor emeritus of the Alexander Blewett III School of Law at the University of Montana and MontGuide co-author.
A home as a gift?
One example is if a widow is trying to decide if she should gift her home while she is alive to her daughter or leave it to her after death. She and her late husband bought the home 40 years ago for $45,000, and now its value is $550,000. While there are personal considerations for one choice over the other, understanding the difference between a stepped-up and carry-over basis may influence the decision, said Eck.
If the widow leaves her home to her daughter in her will, the basis in the home “steps up” from the $45,000 she and her husband paid to buy it, to the value upon her death of $550,000.
“This eliminates the daughter’s income tax liability on appreciation in the property’s value occurring during the mother’s lifetime,” said Shelley Mills, MSU Extension Valley County agent. “In other words, if the daughter sells the house immediately after her mother’s death for $550,000, there is no income tax liability. If she sells the house a year later for $560,000, the daughter will only pay an income tax on the $10,000 capital gain in value after her mother’s death.”
Property transferred as a gift before death has a carry-over basis, meaning the original cost basis of the house, less any depreciation, carries over to the daughter, Goetting said. Because the home was not used in a business, the widow’s original basis of $45,000 was not depreciated and the daughter’s basis in the house is $45,000. If the daughter sells the house for $550,000, she will pay a tax on the appreciation, called capital gain or increase, in the property’s value during her mother’s lifetime. If the daughter is in the highest income tax bracket, she could pay federal and state income taxes in excess of $144,935.
Eck suggests that if estate value falls under the current $12.6 million limit and a parent wants to make a large gift to their children, choosing a stepped-up basis with a gift at death lowers the impact of income taxes and the beneficiary receives the most value from the asset.
“People have worked hard for their property and should look at all the possibilities before making a final decision on whether to make a gift before death or at the time of death and take advantage of the current tax rules,” Goetting said. "If you are contemplating a significant gift, consult your accountant or attorney for an analysis of the tax or other legal consequences you should consider."
More information can be found in the MontGuide “Income Tax Impact When Selling, Gifting, or Leaving Property as an Inheritance at store.msuextension.org/Publications/FamilyFinancialManagement/MT202202HR.pdf. Printed copies are also available from county or reservation Extension offices.