What is “Upstream Gifting” and How Can it Save You Taxes?

With the enactment of the Tax Cuts and Jobs Act of 2017 and the shifting landscape of life expectancy, a novel estate planning method has gained increasing appeal. This method, commonly referred to as "Upstream Gifting," entails giving appreciated assets to parents and/or grandparents further up the generational hierarchy. A significant advantage of upstream gifting is that, upon the demise of the older recipient, these appreciated assets receive a stepped-up income tax basis. Subsequently, those inheriting these assets from the older generation can often sell them without incurring capital gains tax.

The resurgence of interest in this tax strategy is driven by the existing federal estate and gift tax law, which allows individuals to transfer up to $12.06 million worth of assets, whether during their lifetime or after their passing, free from taxation. However, it is crucial to note that changes in the federal estate and gift tax exemption and basis step-up are a concern with the current administration in power.

Upstream gifting offers not only tax benefits but also non-tax-related opportunities. It enables younger generations to provide support to their elders for various purposes, including daily living expenses, medical bills, assisted living facilities, improved housing, and vacations.

Tax Benefits

Traditionally, wealth transfer strategies focus on passing assets to younger generations. In contrast, upstream gifting often involves transferring assets to older generations, who may later devise or bequeath those assets back to the original donor as part of their estate upon their passing. If the original owner were to sell these assets, they might be liable for capital gains tax, calculated as the difference between the purchase price and the property's value at the time of sale. However, when the original donor inherits the assets due to the elder's passing, the basis is adjusted to the fair market value at the date of death. This adjustment can potentially eliminate or significantly reduce any capital gains tax when the original donor eventually sells the asset.

For instance, consider Michael and Susan, a married couple with concentrated stock valued at $1 million and a cost basis of $200,000. If they were to sell this stock, they would face capital gains tax on the $800,000 gain. However, if Michael gifts the real estate to his mother, and she bequeaths it back to him upon her passing, he would receive a stepped-up basis, effectively eliminating the tax on the $800,000 gain. This strategy could also be applied to pre-IPO shares, commercial property or any other asset with a low cost basis.

The upstream transfer can take various forms, including a gift, a sale to a well-structured trust, or a more complex strategy like a grantor retained annuity trust. The tax advantages of upstream gifting can be substantial, especially when dealing with highly appreciated assets that might have significant built-in capital gains. While there are no restrictions on the types of appreciated assets suitable for upstream planning, some assets, such as hard-to-value items like artwork and collectibles, may require appraisals and could be subject to IRS challenges regarding their valuation.

Risks of Upstream Gifting

It is essential to be aware that gifted assets will not receive a basis step-up if the individual passes away within one year of the gift, and the assets revert to the donor. There are also risks associated with transferring assets from a child to a parent. Once the parent owns the property, they have the legal authority to sell it, gift it to someone else, or include it in their estate planning. Moreover, the property might be subject to legal actions or division in case of a divorce. To mitigate these risks, it's advisable for the child to make the gift to a trust for the parent's benefit, carefully crafted by legal professionals with knowledge of both tax and non-tax objectives.

Furthermore, there is a risk that tax laws may change. Presently, the federal estate/gift tax exemption is set to increase yearly until 2026, after which it is scheduled to revert to $6.2 million in 2026 after accounting for inflation. President Biden has proposed reducing the exemption amount to $3.5 million for estates, $1 million for gifts, and eliminating basis adjustments at death. If these changes occur after an upstream gift has been made, the older generation may be subject to federal estate taxes on the gifted assets. Additionally, the original donor may not have an adjusted basis upon receiving the assets back. Thus, upstream gifting is most suitable for individuals who genuinely wish to provide for their parents, irrespective of tax benefits.

In Summary

Utilizing upstream gifts is a strategic method for supporting senior family members. It alleviates the need for elder family members to request financial assistance, can provide income and estate tax advantages, and allows multiple generations to partake in wealth transfer planning. The tax advantages mentioned in this article pertain to federal estate tax, and it's important to consider potential state inheritance tax implications, which may vary depending on individual state laws.