Keep Capital Gains and Estate Taxes at Bay with Upstream Gifting!

Transcript: 

Hey guys, Mike Frontera here, back with another Retirement Theory video.

So, you know that old saying “it’s better to give than to receive”? Well, today I’m going to show you a tax strategy that can really make that saying ring true. It’s known as “upstream gifting” and it can be a powerful way to avoid thousands of dollars in capital gains and estate taxes. So let’s talk about what it is, how you can use it to your benefit, and some possible drawbacks to be aware of.

OK, upstream gifting is basically the act of gifting highly appreciated assets to an older family member, like a parent or even grandparent. Now, of course, you may do this as a thank you for all the wonderful things your parent has done for you over the years, but in this case we’re primarily looking to save some tax money.

Ok, let’s see how this might work in action…See how it might work.

Here we have Paul and Wanda. They have a stock account that they’ve invested a total of $100,000 into, and currently has a value of $2M. So they gift the $2M stock to Wanda’s dad, Jerry, who is 92 years old. A couple years later, with the stock account now worth $2.2M, Jerry passes away, leaving the stock to Paul and Wanda. With the current step up in basis rules at death, Paul and Wanda receive the $2.2M stock along with a basis equal to the $2.2M value. So Paul and Wanda can now sell the stock without paying a dime in capital gains tax.

Sounds great, but not so fast…let’s look at how this blows up in a few different ways.

First, Paul and Wanda lose control of the stock. So Jerry could decide to try to double his money and bring the $2M to the Bellagio and putting it all on red. Maybe he’s not that adventurous, but in reality, he could do anything he wants with that money. Of course, his creditors could too if he gets into debt. Or needs long-term care. Jerry could also decide in the end to leave the money to his favorite child, Mary, Wanda’s sister. Or he could get married and end up leaving all his money to his new wife and her family.

On the tax front there’s also risks. First, the capital gains step up does not occur unless Jerry lives at least one year after that gift was made. Speaking of gifts, the annual gift exclusion is only $17,000 this year. That means Paul and Wanda will use up a big chunk of their lifetime gift exemption by transferring that much stock directly to Jerry. Now, right now that gift exemption is really high, like almost $13M. So that may not be a concern. But that sky high exemption is part of the Trump era Tax Cut and Jobs Act, which sunsets in 2026. AT that point, the gift and estate tax exemption is scheduled to be cut in half. And that tax rate is 40%, that’s much higher than the capital gains tax rate that Paul and Wanda are looking to avoid.

So it seems, the bigger the gift, the bigger the number (and severity) of risks. As they say, “more money, more problems.”

Now, some of these risks can be mitigated, of course. So first, the overall strategy works much better when Jerry’s total estate, including the gift, is far below the estate tax exemption.

Paul and Wanda can also choose to set up a trust to benefit Jerry instead of gifting the asset outright. If it’s drafted properly, the trust can limit how Jerry can use the money…though it’s important to recognize that he would still need to have what’s called a general testamentary power of appointment. This basically means that Jerry can direct where the asset goes at death, in order to be included in his estate and be eligible for the basis step up. A trust that benefits Paul and Wanda may even avoid the one-year waiting period for basis step up. So assuming Jerry was also under the generation skipping tax exemption, which happens to be the same as the gifting and estate tax exemption, then the asset could benefit Paul and Wanda and ultimately pass to their son Billy, without any estate tax to be paid.

Upstream gifting can be an exceedingly powerful planning strategy. But with great power, comes great responsibility. So… don’t try this at home. Be sure to consult a qualified estate or tax attorney before you start  moving large assets around.

So, do you have questions for me? Let me know. Come visit me at www.retirementtheory.com or send me an e-mail at Mike@retirementtheory.com. Did you click subscribe on this video or follow me on Facebook? I think that you should. You'll continue to see videos like these on everything retirement planning. Once again, thank you for joining me, we'll see you next time.

Sources:

1. https://www.fidelity.com/learning-center/wealth-management-insights/tax-efficient-intergenerational-wealth-transfer
2. https://www.wealthmanagement.com/high-net-worth/upstream-gifts-he-gon-give-it-ya
3. https://www.fidelity.com/learning-center/wealth-management-insights/TCJA-sunset-strategies#:~:text=As%20of%20January%201%2C%202026,half%2C%20and%20adjusted%20for%20inflation.