Gift Tax
There are usually no immediate tax consequences for either the giver or the recipient of a gift at the time the gift is given.
The person receiving the gift generally doesn’t have any tax consequences when they accept a gift. A gift that isn’t in exchange for work is not income, so it is not taxed.
The person giving the gift usually also doesn’t have any tax consequences when they give a gift, unless they have reached their lifetime gift tax exclusion (which is $12.92 million as of 2023, and adjusts yearly based on inflation). Once someone has given more than that amount (either as gifts during their lifetime or as an inheritance after their death), then any additional amount is taxable under the gift and estate tax rules.
The person giving the gift doesn’t have to pay any capital gains taxes on assets given away as a gift, but they also don’t get to deduct any losses if it has gone down in value (even if it’s a business or investment asset). For that reason, if a parent wants to gift an investment asset (such as real estate or stock) that has gone down in value, it may be more adventitious for them to instead sell the asset to an unrelated party, and then gift the proceeds instead.
The person giving the gift does have to file a gift tax return if they gift more than $17,000 (as of 2023) to any one person. It’s just an informational return, and no tax is owed as long as the giver remains within their lifetime gift tax exclusion amount.
Capital Gains and the Basis of a Gift
Even if there are no taxes due when the gift is given, it’s important to understand how gifting an asset affects the tax basis of the asset, because that becomes important later on when the recipient of the gift eventually sells it.
When an asset has gone up in value over time, and the owner gives it as a gift to another person, the original owner’s basis transfers to the recipient. It would be more beneficial for the recipient if they were allowed to use the current market value when they receive the gift as the basis, as they could if it was an inheritance. But the tax code doesn’t do any favors for the recipient of gifts, so that lower original basis means they’ll have to pay more in capital gains tax when they eventually sell it. But at least the giver of the gift doesn’t have to pay any capital gains when giving away an asset that has gone up in value.
On the other hand, if it’s an asset that has gone down in value (such as real estate in a declining area), then the basis is handled differently. If the value continues to go down, and the recipient of the gift later sells it at an even lower value than when it was worth at the time they received the gift, then their basis is the fair market value at the time they received the gift. That’s also not a good thing for the recipient of the gift because it reduces the amount of a tax deduction they can take for the reduced value of the asset. So in that case too, the tax code doesn’t treat recipients of gifts favorably when it comes to capital gains taxes.
What’s “basis”?
When you sell an asset, such as a house, the basis is the amount you can subtract from the sale price to calculate how much capital gain you have (the taxable profit). So a higher basis is better when you sell something, because it means less capital gain, which means paying less capital gains tax. Your basis may just be the price you paid for the asset. But it can also be adjusted over time because it increases when you spend more money to improve the asset (such as replacing the roof on a rental property). Your basis can also decrease over time if it’s a business asset such as a rental property because you get to subtract a little of the expense each year from your profit (that’s depreciation).
Suspended Losses
What are suspended losses?
When you own a rental property that has negative taxable income, sometimes you can deduct that negative income from your other taxable income to reduce your tax bill. But in some cases you can’t, and so that negative income gets carried forward until you can use it up in a future tax year. That’s called suspended losses.
If the gift is a rental property and has suspended losses, the amount of these losses is added to the basis just before transferring the gift. So the recipient of the gift gets the gift giver’s adjusted basis plus their unused suspended losses. This is a good thing because it means the suspended losses at least don’t just disappear, they benefit the recipient of the gift by adding to its basis.
This is the relevant reference in the tax code:
In the case of a disposition of any interest in a passive activity by gift—
IRC 469(j)(6)
(A) the basis of such interest immediately before the transfer shall be increased by the amount of any passive activity losses allocable to such interest with respect to which a deduction has not been allowed by reason of subsection (a), and
(B) such losses shall not be allowable as a deduction for any taxable year.
The Advantage of Making it an Inheritance Instead
If it’s possible to wait and transfer the asset to an heir after the death of the owner, there is a major tax advantage to doing that. The advantage to waiting and making it an inheritance is that the recipient of the gifted items gets a “stepped-up basis.” If an asset passes to an heir as an inheritance, the heir’s basis becomes the current fair market value of the asset at the time they inherit it.
While you are alive, if you gift an asset that has gone up in value, your basis in the asset transfers to the recipient. If it’s a rental property that has been depreciated over a number of years, the remaining basis might be very little. That would mean a very large capital gains tax bill if the recipient later sells it. But if it passes to an heir as an inheritance, the heir’s basis becomes the current fair market value of the asset at the time they inherit it. That can mean a huge savings in capital gains taxes if they sell it.
Additionally, inherited assets are always considered to qualify for the long-term capital gains tax rate regardless of how long the decedent or the heir owned it. That’s a good thing because the long-term capital gains tax rate is lower than the short-term rate.
Obviously, waiting until death to give away something is not going to be an option in all situations. But what you don’t want to do is give away a major asset just before death if it is an asset that has gone up in value (such as real estate or stocks). Or even worse, if you have a major asset that has gone up in value, you don’t want to sell it just before death and have to pay capital gains taxes. If you instead hold the asset and gift it as part of an inheritance, your heirs get it at the stepped up basis of its fair market value at the time they inherit it. That means they can immediately sell the asset if they would like, and they get the full proceeds from the sale without owing any capital gains taxes. That can avoid either the giver or the recipient from having to pay any income tax on the sale of the asset.
That’s an example of why it’s a very good idea to talk to a qualified tax professional about tax planning before selling a major asset.
