Originally published in the Saratoga Business Journal.
What is a capital gain? Generally, a capital gain results from a sale of an asset, such as a stock, at a higher price than the owner originally paid. What the owner paid for the asset is known as the cost basis. If the sale price is higher than the cost basis, the difference between the two is a capital gain.
A long-term capital gain is a gain resulting from a holding period of more than one year. For most taxpayers, a long-term capital gain is taxed at 15 percent (20 percent for the top tax bracket). A short-term capital gain is a gain resulting from a holding period of 12 months or less. A short-term capital gain is taxed as ordinary income, which varies depending on the taxpayer’s income tax bracket.
Beyond the basics of capital gains tax rules, we must consider the effects of gifting and inheriting capital assets. When considering these events, we must also think about the possible gift tax and estate tax ramifications. The current federal annual gift tax exclusion amount is $14,000 per person.
This means that a donor can give each person $14,000 per year without having to pay or report any gift taxes. If the donor is married, they can give away $28,000 per year per person. It is important to note that while for tax purposes, a gift of $14,000 or less is disregarded, such a gift may be considered a transfer that could trigger a penalty period for a Medicaid look-back period, if the donor has to go into a nursing home within five years of making the gift.
If a donor gifts more than the annual gift tax exclusion amount, that donor is obligated to file a gift tax return (IRS Form 709) to report the excess above the exclusion amount. For example, a widow gives her son $20,000 in one calendar year. She must file a gift tax return and report $6,000 (the excess above the exclusion amount). She will not owe any taxes on making the gift and the son will not owe any taxes for receiving the gift at that time.
However, if the widow passes away with more than the federal estate tax exclusion amount, that gift, along with any other reportable gifts that she made during her lifetime, will be included in her gross estate for federal estate tax assessment purposes. The current federal estate tax exclusion amount is $5.43 million. This amount is adjusted annually for inflation. In general, there is no gift tax in New York. The current New York estate tax exclusion amount is $3,125,000 until April 1, 2016, when it will be increased to $4,187,500 until April 1, 2017, when it will be increased to $5.25 million.
The most common capital asset that is gifted or inherited is stock. Many older people wish to gift their assets to their loved ones while they are still alive to see it. This may not be a good idea for tax purposes or for long-term care and Medicaid planning purposes.
The concepts of carryover basis and stepped-up basis are the key focus to the capital gains planning discussion surrounding the comparison of gifting versus bequeathing (i.e., naming someone in your will). For tax purposes, if someone gifts a capital asset during their lifetime, the recipient steps into the donors shoes and takes their basis. This is known as carryover basis. In contrast, if someone inherits a capital asset they receive a stepped-up basis in the asset as of the date of death.
The easiest way to illustrate this is with an example. Let’s assume that the capital asset is 1,000 shares of stock with a cost basis of $5 per share (total cost basis of $5,000). The stock is worth $25 per share today (total value of $25,000). If a donor gifts the stock while she is alive, the recipient will take her basis of $5 per share, which means that if the recipient were to sell the stock, they would incur a capital gain of $20,000, resulting in a $3,000 capital gains tax.
If that same donor passes away and the recipient inherits the stock, they will receive a stepped-up basis to $25 per share (the value on the date of death). If the recipient were to sell the stock for $25 per share, they would not owe any capital gains tax as a result of the stepped-up basis. It is important to note that there are variations of basis step-up adjustments that result from joint ownership, depending on the relationship of the joint owner to the decedent. If capital gains tax is the only consideration when determining whether it is best to gift or bequeath, the step-up in basis is a significant advantage.
With the holidays approaching, you may have questions about what’s right for your situation, to gift or not to gift? As discussed, tax is not the only factor that should be considered when making this determination. It is important to consult with your estate planning attorney, in conjunction with your financial advisor and accountant, before making gifting decisions.