Lifetime Gifts versus Transfers Upon Death
You have two options when it comes to transferring and passing your assets to your heirs and beneficiaries. You can give them away during your lifetime or you can transfer them upon your death. It’s your call. Is one option necessarily better than the other option? It always depends on the facts, situation, and the circumstances. Think about the following:
The Parable of Two Brothers and 2 Acres of Land.
Shortly after the Great Depression of the 1930’s, two brothers, Allen and Bob, were walking over some land in south Florida when they spotted a “for sale” sign. The sign said “2 Acres at $500 per Acre”. The two brothers made a deal to buy the land for $100 down and $100 per year for the next four years. During this time, the brothers worked together to make the payments sometimes loaning money to the other to do so. At the end of four years, the two brothers were the proud owners of two acres of everglades and swampland with the significant investment of $500 per acre. They had no way of knowing what would happen to enhance the value of those two acres through several generations of family transfers.
Time passed quickly and after the end of World War II and the Korean War, soldiers were returning home and getting out of the military. They were looking for a place to put down roots and raise a family. The warm sunny climate of south Florida had become a natural drawing card. Developers were repurposing the land into residential and commercial development.
As Allen and Bob were beginning to grow old, both brothers decided to give their one acre to their sons so as to avoid probate upon their death. At this time, the land that had been bought for $500 per acre was valued at $10,000 per acre. So, the two brothers transferred their ownership in the land to their sons, Charles and Dan.
Charles and Dan held onto the land for several years. In the early 1980’s the value of the land had increased to $100,000 per acre. This was a considerable increase in value for a $500 piece of swampland. Again, wanting to avoid probate, Charles and Dan gave the land to their sons, Eric and Fred.
Eric and Fred each were the proud owners of one acre of land worth $100,000 that had been purchased for $500. Late in life they each prepared a will and left their one acre of land to their sons, Greg and Harvey.
After the wills were prepared, a commercial real estate developer approached Eric and Fred with a very lucrative contract to buy their one acre of land which just happened to be the only remaining undeveloped parcels in what has now become South Beach Miami for $1 million per acre. Not bad, a $500 acre of swampland had now become a part of South Beach Miami worth $1 million.
This presented the family with a decision. Do Eric and Fred sell or not sell? Do Eric and Fred give the property to Greg and Harvey now and let them sell it? At this point, there will be a hefty income tax to whoever the seller is. Or is there another option?
Eric decided to deed his acre to Greg and Greg executed the sale. Greg’s gain on the sale was $999,500 less the closing expenses. Greg’s gain is measured based on the sale price of $1 million less the ORIGINAL PURCHASE PRICE of $500. Since all of the transfers had been done by gifts DURING THE LIFE of the owner, the seller, in this case it was Greg, looks to the original investment of $500 by Allen to determine his taxable gain. Greg’s tax bite was somewhere around $150,000. Still, it was not a bad deal since Greg netted after taxes approximately $850,000.
Fred reminded Harvey that there was a fairly long option period that they had to accept the contract. After some discussion, Fred and his son Harvey decided to take a different route. Harvey told his dad that he would prefer to inherit the land upon Fred’s passing as opposed to being gifted the land during Fred’s lifetime. Fred looked at his son, smiled, and very simply said “Good Call”.
Not very long after Fred and Harvey’s conversation, Fred passed away. Harvey inherited the one acre that had been purchased in the 1930’s for $500 that was now worth $1 million. Harvey executed the sale and received a check for $1 million less the closing expenses.
What about the income tax? Bottom line, the income tax on this particular transaction goes away – it disappears. As I like to say “all sins are forgiven”. In most cases, property received through an inheritance receives what we call a “step up in basis”. This means that when Harvey inherits the one acre valued at $1 million, Harvey’s future tax gain is now going to be measured based on the difference between the fair market value at the time of Fred’s death, $1 million in this case, compared to the sales price, $1 million in this case. Harvey has sold the one acre of land for $1 million that has a tax cost basis due to the step up in basis of $1 million. Harvey has broken even on the sale. Harvey has no gain and no loss, except for the closing expenses. Harvey has avoided the tax bite of around $150,000 on the true gain of approximately $999,500 and has deposited the entire $1 million (less the closing expenses) into his bank account. This tactic has just saved Harvey approximately $150,000 of income tax.
The illustration above shows two very different tax outcomes depending on when the property is transferred either by a lifetime gift or by inheritance upon the passing of the owner. This illustration serves to show the importance of good estate planning.