With the stock market galloping to new heights, more wealthy folks have been turning to a creative strategy to mitigate taxes on portfolio gains by transferring ownership of assets to their parents instead of their kids.
Called “upstream planning”, the idea is to get appreciated assets out of an estate to an older generation, then later inherit them with a step-up in cost basis so the gains are absorbed into the original owners’ wealth with no capital gains tax hit.
“We’re having a lot of conversations with clients about this because people have a lot of appreciated assets,” says Pamela Lucina, chief fiduciary officer at Northern Trust in Chicago. “But there are both benefits and drawbacks, so you have to make sure the strategy fits the facts of your situation.”
The upstream strategy can make sense if taxes are avoided on both the gift to the parents and the parents’ estate after they die. So the size of the estates of both the younger and older generation—and whether each has used their estate and gift tax exemption—are key factors to consider.
This year’s estate and gift tax exemption is a record-high US$13.1 million per person, or US$26.2 million per couple, but under current law this higher exemption level will expire and drop to around US$7 million at the end of next year. That is, unless Congress extends it at its current level.
While some folks may be eager to make upstream appreciated gifts soon to use up the higher exemption before it drops, they have to take into account whether the gift would create an estate-tax burden for the parents once the exemption drops to a lower level, Lucina says.
Typically for this to work well the older generation has less wealth than the younger, and they have not yet used any of their own exemption, Lucina says.
But there are a number of risks to consider, she says.
If your parents are in debt, you could lose the assets to creditors, “and receiving the assets could impact your parent’s ability to qualify for things like Medicaid, so be careful you’re not just looking at taxes, but the whole picture,” Lucina says.
Keep in mind that by gifting the assets outright you give up control over them.
“Your parents could leave the asset to someone else—they could remarry and leave it to their new spouse or leave it to your sibling,” Lucina says. “There’s a risk that you never see those assets again.”
The health of the recipient of the gift must also be considered. If the parents die within a year of receiving the appreciated assets as a gift, you won’t get the step-up in cost basis on the asset.
Recently the strategy was adopted by one of Lucina’s clients who had five greatly appreciated stocks, she says.
“This is an only child, so there’s no risk it would go to other siblings, with a really good relationship and open conversation around estate planning with the parents,” Lucina says.
The most common assets to use are publicly traded securities because their value is established by the markets.
While it’s possible to transfer real assets such as artwork, they can be difficult to value and could attract scrutiny and a challenge by the Internal Revenue Service.
Real estate typically isn’t transferred because owners already have a tax benefit when they sell through a capital gains tax exclusion for primary residence sales, Lucina says.
When a primary residence is sold, the first US$250,000 of gains are excluded from capital gains taxes for singles and US$500,000 for couples.
To mitigate some of the risks, you can use a trust to transfer the upstream gift so it is more likely the assets are left to you, but the assets may still be subject to your parent’s creditors, Lucina says. “This is a good example of why open communication with parents around estate planning is important when trying to optimize the family’s wealth.”
This Barron’s article was legally licensed by AdvisorStream.
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