How Rich Americans Save on Taxes by Gifting Stock and Real Estate to Their Parents
Selling appreciated assets like stock and real estate can result in high capital gains taxes. However, wealthy individuals can save significantly by gifting these assets to their parents, inheriting them back, and then selling them.
Tax PlanningEstate PlanningCapital Gains TaxReal EstateStockReal EstateOct 13, 2024
How Upstream Planning Works
When a wealthy individual sells an appreciated asset, such as stock or real estate, they are subject to capital gains tax. This tax is calculated based on the difference between the asset's purchase price (cost basis) and its sale price. However, if the individual gifts the asset to their parents and later inherits it, the cost basis is reset to the asset's fair market value at the time of inheritance. This can result in substantial tax savings.
For example, a top earner looking to sell shares that have appreciated by $1 million would typically face a capital gains tax of about $238,000, according to Pam Lucina, chief fiduciary officer at Northern Trust. However, if the individual gifts the stock to their parents and sells it after inheriting it, they only pay the 23.8% tax rate on the appreciation since their parents' death, even if the stock's value has increased further.
Key Considerations
1. Choosing the Right Assets The most effective assets for upstream planning are those with a low cost basis relative to their current value. Publicly-held stock, real estate, and private business interests are popular choices.\n2. Risks and Family Dynamics Upstream planning is a powerful but risky tool. Individuals can lose their assets if their parents decide to share the wealth with a new spouse or other children. Pam Lucina estimates that only about 25% of clients actually go through with upstream planning after discussing the risks.\n3. Estate Tax Considerations Thanks to tax cuts made during the Trump administration, individuals can gift or bequeath $13.61 million before triggering a 40% federal estate tax. This high exemption threshold has made upstream planning more popular. However, the tax cuts are set to expire at the end of 2025, barring action by Congress.
Practical Implementation
Robert Strauss, a partner at estate planning firm Weinstock Manion, typically uses upstream planning with ultra-rich clients who have already used their exemption but have less-wealthy parents who haven't. These clients can place assets in a trust that benefits their parents until their passing and then the children. After the grandparents die, the children inherit the assets with a stepped-up basis, as long as the grandparents' estate does not exceed $27.22 million, the exemption for a married couple.
Important Precautions
1. Parents' Creditors The parents are usually given power of appointment over the assets to ensure they are included in their taxable estate. This legal right also allows their creditors to pursue the assets.\n2. Family Agreement It's crucial to get the whole family on board. Involving more people can make the plan more likely to fall apart. For instance, the parents might change their minds about leaving a bigger inheritance to one child, even if that child gifted substantial assets to them.\n3. Age of the Parents The age of the parents is a critical factor. Strauss typically uses upstream transfers when the wealth creator's parents are at least in their seventies or expected to live five more years or less. If the parents die within one year of the transfer, the assets do not receive a step-up in basis.
Navigating the Challenges
Upstream planning involves a delicate balance. While the assets are tied up during the parents' lifetime, the tax law and the value of the assets can fluctuate. It's possible to unintentionally trigger estate taxes if the assets exceed the exemption amount by the time the parents die. Ideally, the goal is to target the exemption amount precisely, but this can be challenging due to changing asset values and tax laws.
Conclusion
Upstream planning can be a highly effective strategy for saving on taxes, but it requires careful consideration of the risks and family dynamics. Wealthy individuals should work closely with their financial and legal advisors to ensure that their plans are well-executed and that the benefits outweigh the risks.
Frequently Asked Questions
What is upstream planning in the context of tax savings?
Upstream planning is a strategy where wealthy individuals gift appreciated assets like stock and real estate to their parents. These assets are then inherited back by the original owner after the parents' death, allowing for a stepped-up basis and reduced capital gains tax.
What are the key assets typically used in upstream planning?
The most effective assets for upstream planning are those with a low cost basis relative to their current value, such as publicly-held stock, real estate, and private business interests.
What are the risks associated with upstream planning?
The main risks include the possibility of losing assets if parents decide to share them with a new spouse or other children, as well as the potential for family disagreements and the involvement of the parents' creditors.
How does the age of the parents impact upstream planning?
The age of the parents is crucial. Upstream planning is typically used when the parents are at least in their seventies or expected to live five more years or less. If the parents die within one year of the transfer, the assets do not receive a step-up in basis.
What is the current federal estate tax exemption amount, and how does it impact upstream planning?
The current federal estate tax exemption amount is $13.61 million for individuals and $27.22 million for married couples. This high threshold has made upstream planning more popular, but it is set to expire at the end of 2025, potentially affecting future planning.
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