Clients who wish to minimize the tax burden on their estates and heirs may have heard that deathbed transfers — gifts of money or property bequeathed before death that reduce the size of the total estate — are effective ways to save heirs money.
But while a smaller estate should, in theory, mean fewer taxes, in practice it's not so cut and dried. To convolute matters further, deathbed gifts can result in a bigger tax burden for heirs in some cases, which is why deathbed estate transfers may not be the best way to protect wealth.
Deathbed gifts are a complex and nuanced topic and the reality is that a one-size-fits-all protocol for handling these situations doesn't exist. What is best for your client and their heirs will depend on a variety of factors.
The taxman cometh?
The first variable to consider is the size of the client's estate. That's because the federal estate tax applies only to estates worth a minimum of $12.06 million, or $24.12 million in the case of married couples, with a slight bump in those figures coming in 2023. The vast majority of estates won't meet this threshold, thus paying federal estate tax is largely not a concern.
State tax rules, however, are much more complicated. Currently, 12 states and the District of Columbia impose estate taxes and six states impose inheritance tax (Maryland imposes both). The rules around estate taxes vary widely from state to state, with variations in tax rates and exemption limits. In some cases, rates are even dictated based on the heir's relationship with the deceased.
For clients living in one of these states, deathbed gifts might lessen the tax burden on heirs, though it is imperative to consult a lawyer who specializes in estate law before taking action. That said, the majority of states have neither estate or inheritance tax. That means for clients living in those states whose estates don't meet the federal minimum threshold, deathbed gifts may actually result in more taxes, not less, for heirs.
Not why, but when
The next factor in the equation is timing. When heirs inherit assets,
As an example, let's say your client purchased a home in 1968 for $30,000 and it is now worth $500,000. If the client leaves the property to her son when she dies and he sells it for $500,000, he will have zero taxable gain on the sale because it is subject to the step-up in basis; the cost basis is determined by the valuation at the time of the mother's death. However, if she gifts the property to her son shortly before she dies, he takes a carry-over basis and is subject to the same taxable gain that the decedent would have had — in this case, a taxable gain of $470,000, based on decades of appreciation.
In the majority of cases, it makes better financial sense to let property remain in the estate, rather than transferring it.
Importantly, one thing to remember is that the step-up in basis rules do not apply to all assets. Assets that step up include real estate, individual securities, mutual funds and ETFs, businesses, art, furnishings, and collectibles. Notably, they do not include individual retirement accounts, such as IRAs and Roth IRAs, employer-sponsored retirement plans such as 401(k)s or 403(b)s, and tax-deferred annuities.
But wait, there's more: In community property states, assets held by a married couple in a revocable living trust may be subject to a "double step-up basis." In this case, when one spouse dies and the other inherits the property, the step-up basis is based on the value of those assets at the time of the first spouse's death, potentially mitigating a large capital gain if the second spouse chooses to sell it. If the second spouse chooses to bequeath those assets to their heirs, the step-up basis will be based on the fair market value at the time of the second spouse's death.
Not too little, not too late
In most cases, it's probably wiser to keep assets in the estate. But if the client has already transferred assets, is it too late to do anything about it?
Maybe not.
If the client is still living, there may be ways to avoid a large tax gain when and if the assets are sold. For instance, if a client has gifted his home to his children but continues to live there without paying rent, his heirs could argue that this should be considered a "retained interest" by the IRS, which would pull the home back into the estate. Businesses and farms may also offer the possibility of retained interest. If a business has been transferred to children but the original owner continues to receive income from it, it can be argued that the business should be included in the estate.
Even when heirs are planning to keep a business or farm in the family, they can still benefit from step-up in basis rules. Depreciable farm and business assets are also subject to the step-up in basis rules, giving them a new income tax basis and effectively restarting their depreciation.
Give the gift of tax exclusion
In instances where reducing the size of the client's estate makes sense, the annual gift tax exclusion provides a workaround of sorts. Beginning in 2023, individuals may annually give up to $17,000 tax free to as many individuals as he or she wishes, which represents a slight increase from 2022. Meanwhile, married couples may give up to $34,000 per recipient. This removes the money from the estate without incurring taxes for the recipients.
Estates can be tricky business, especially for clients who live in one of the 18 states with inheritance or estate taxes, which is why I always recommend advisors seek the advice of a qualified estate attorney. While the majority of estates won't benefit from deathbed giving, there are circumstances in which they may help the client achieve the goal of saving their heirs as much money as possible. Understanding the pros and cons of deathbed transfers and consulting a qualified estate attorney is critical to ensuring the client's wishes are ultimately realized.
