Sometimes people will transfer title of their assets to their adult children while they are living, thinking it will make things easier for their children when something happens to them. Doing this will prevent the court from controlling the assets if you become incapacitated and it will avoid probate when you die. And while there can be valid tax reasons to transfer some assets now, it can also create problems.
First, when you give away an asset, it's gone. You may think your children will give it back to you if you change your mind, but they don't have to, and things can change in families when money is involved. They could sell the asset against your wishes, they could lose it to creditors, or they could be influenced by a spouse. If you outlive your children or they divorce, a daughter- or son-in-law could end up owning the asset. Would she or he give it back to you?
Second, there could be tax problems. Currently, when you give someone other than your spouse more than $13,000 in one year, a gift tax may be involved. And when your children sell the asset, there will probably be a capital gains tax. That's because, under current law, the asset would not receive a stepped-up basis.
The basis of an asset is the value used to determine gain or loss for income tax purposes; in other words, the basis is what you paid for the asset. If you give an appreciated asset to your children while you are living, it keeps your old basis (what you paid for it). But if they receive it as an inheritance after you die, it may receive a new stepped-up basis as of the date of your death.*
Let's look at an example. Let's say Bob purchased his home back in 1955 for $50,000 and today it's worth $250,000. He gives it to his son Tom, who then sells it for $250,000. Because Bob transferred title to Tom while he was living, the house keeps Bob's original cost basis of $50,000. That means Tom has a $200,000 gain on the sale and under current tax law, he will have to pay $30,000 in capital gains tax. (Currently, the top capital gains rate on assets held longer than 12 months is 15%.)
Now, let's look at the other scenario. Tom receives the house as an inheritance after Bob dies instead of as a gift while Bob was living. Because it is received as an inheritance instead of as a gift, the property receives a new stepped-up basis to the market value as of the date of Bob's death, which is $250,000. Now when Tom sells the house for $250,000, there is no gain on the sale...and no capital gains tax to pay.
Substantial gifts may also disqualify you from receiving Medicaid and SSI (Supplemental Security Income) benefits for a significant period of time.
Gifting can be a great way to reduce estate taxes if your estate is larger and you can afford to give away an asset. But never give away an asset you may need later. And make sure you consult with an experienced professional.
*NOTE: Beginning January 1, 2010 the amount of assets that can receive a step-up in basis is limited. Most estates will be able to step up $1.3 million worth of assets. An additional $3 million of assets left directly to a surviving spouse can also be stepped up to full market value. Assets that do not receive the stepped-up value will be taxed based on the deceased owner's original cost basis (what the owner paid for it) or the fair market value, whichever is less. This tax law change was put into effect to offset the one-year repeal of the federal estate tax in 2010.