October 24, 2022

The pandemic put deathbed gifts in the spotlight. But are they the right financial decision in most cases? Jamie Hargrove explains the tax implications and why you should avoid this type of gifting.

The days or weeks leading up to a loved one’s death are an emotional time—and heightened emotions rarely make for sound financial decisions.

A common assumption among family members is that they should get all the assets out of their relative’s estate before that person passes away. However, most people are not exactly sure why they should get the assets out. Maybe they read a book on avoiding probate, or perhaps they have heard horror stories about huge tax hits and think that a last-minute transfer will help them avoid inheritance taxes, estate taxes, or both.

I’ve been in practice for almost 40 years, and I’ve lost track of how many times I have gotten a call from a client, prospective client, or friend saying they are about to transfer—or in some cases, already have transferred—all assets out of a parent’s or grandparent’s name because their loved one was about to die.

While there are always exceptions, the truth is that in the vast majority of cases it is a bad idea to transfer assets out of a person’s name just before death. One reason is a loss of step-up in income tax basis as a result of the transfer. This may sound very technical, and the step-up income tax basis rules are somewhat complex, but the practical application is fairly straightforward. Understanding it will make it easier to make smart decisions in emotionally fraught circumstances.

What’s a Taxable Estate?

Before we get into the step-up basis rules, though, it’s important to understand what we mean by a taxable estate. It does not mean that an estate will necessarily pay tax, only that it is potentially subject to being taxed. In reality, most estates will not pay any tax—no inheritance tax, no estate tax.

Consequently, even though an estate is “taxable,” there really are no taxes due. There are a few states that still have an inheritance tax and, of course, in very large estates you may be subject to federal estate tax. Those situations, however, are the exception, not the rule, and even in those situations, the laws are drafted in such a way as to eliminate any benefits from last-minute deathbed planning options.

How Step-Ups Step into the Process

Back to the step-up basis: any assets that are owned, whether in an individual’s name or in an individual’s living trust, will receive a step-up in income tax basis as a result of being part of the decedent’s taxable estate.

Assume, for example, that you bought one share of Apple stock when it was selling for $10 per share. Let’s then assume that at the moment of your death, the stock was selling for $100 per share. If you die with that share of stock in your name (or titled in your living trust), the share will be subject to a step-up in its income tax basis, meaning it gets a new income tax basis equal to $100 per share. Had the one share of stock been sold the day before you died, there would have been a $90 taxable gain on the share of stock.

If you gift that share of stock to your son the day before you die, he then takes a carryover basis, meaning his income tax basis equals yours at the time of the gift. If he sells the stock for $100, he will pay taxes on the $90 gain. However, if your son had received the stock under your will and sold it afterward for $100, he would have zero gain and no taxes.

This same principle works with a family farm. Assume, for example, that your grandmother and grandfather purchased a family farm many years ago for $50,000, and that this farm is now worth $550,000. If the family rushes in and has Granddad (or his power of attorney) transfer the farm to the kids or grandkids just before he dies, the kids or grandkids will receive the farm with the original income tax basis of $50,000. This means that when Granddad dies and the property is sold, there will be a $500,000 taxable gain on the sale of that property.

Had the family not rushed in to get all the assets out of Granddad’s estate, the farm would have been subject to the step-up in basis rules, with a new basis of $550,000 when it passed out of his estate to the kids or grandkids.

Doing nothing before the grantor’s death, therefore, saves the family from paying tax on a gain of $500,000.

Again, in most cases, there are no inheritance tax or estate tax consequences to having the property remain in the estate. In fact, for most, there is a huge income tax benefit to simply doing nothing.

Oops. What If the Assets Were Already Transferred?

Is it too late to do something if the transfer has already been made? Maybe not. If Granddad is still living, then in many cases there is some good news. Particularly with a family farm or homestead property, there may be a retained interest in the property, which may trigger inclusion in a relative’s taxable estate. This goes against the general rule that transferring property or assets out of your estate means they will not be part of your taxable estate for the step-up in basis rules. There are a whole set of cases, however, where people have made transfers, sometimes years in advance of a death, and because of a retained interest in the transfer, the IRS argued that the transferred asset (the family farm in this case) is still taxed in the estate.

Assume that, as part of basic estate planning, the family decides to get the family farm out of Granddad’s estate. This planning was completed many years ago when the estate tax exemption was $600,000. The concern was that the farm might appreciate beyond $600,000 and trigger an estate tax that, at that time, would have been 55%. Consequently, planning was set up to have the property transferred to other family members or in trust. The farm may also be held in a family limited partnership or a family limited liability company to facilitate the planning.

Since that transfer was made, however, a huge $12 million-plus estate tax exemption has gone into effect, and there is no inheritance tax in most states. You now have a situation where that farm would not have triggered inheritance or estate taxes, yet the family loses the step-up in income tax basis because the property is not part of the estate.

This may be avoidable, however, if there was a retained interest in the use of the farm as a part of the transfer; for example, if Granddad had transferred the property to his children but continued to live in the home until his death and there was no lease of the home back to Granddad. Granddad’s choice to continue living on the farm is considered a retained interest by the IRS, which pulls the farm back into his taxable estate.

Perfect! That’s exactly what you want in most cases.

Note that if there had been a lease agreement in place, with Granddad making lease payments monthly, quarterly, or annually, this argument wouldn’t work. It’s only when he lived on the farm rent-free that we have an argument for a step-up in basis.

The good news is that, in many cases, it can be successfully argued that such continued use of the residence by Granddad is a retained interest. Therefore, the property would be included in the taxable estate. Being included in the taxable estate may have zero tax impact for inheritance and estate tax purposes, but it offers the ability to take advantage of the step-up in basis on the farm. When the kids sell the family farm after Granddad dies, there will be little or no income taxes on the sale.

Another example of a retained interest would be if Granddad continued to receive income off some crops or land rental. Such income or interest in the profits from the farming operation would be a retained interest and arguably allow for the property to be included in the estate under this retained interest exception.

These step-up in basis rules are also important when assets, such as a family farm, are likely to be kept over multiple generations. Since the family doesn’t anticipate selling the farm anytime soon, they may not be concerned about triggering taxes when the property is ultimately sold.

However, there are still benefits to taking advantage of the step-up in basis rules.

In this case, the main reason to take advantage of the step-up in basis rules is to get a step-up in depreciable farm assets. There are lots of items related to a farm (fences, roadways, outbuildings, barns, etc.) that have long been fully depreciated down to a zero basis. Working with the step-up in basis rules will give those depreciable items a new income tax basis and effectively allow for a restart on the depreciation of those farm improvements.

Capital gains taxes and the potential to restart depreciation on depreciable assets can amount to a lot of money, so keep this information in mind before you transfer those assets at the deathbed and before you give up on assets already transferred.

There is a high likelihood that the step-up in basis rules and the retained interest rules apply to someone in your family or someone you know. Taking the time to understand them now can save a lot of expense, stress, and heartache later.