Advisor Connections Newsletter™
June 7, 2016
The Unknown Pitfalls of Gifting
The Unknown Pitfalls of Gifting
We commonly see clients desiring to make gifts to adult children. Sometimes gifts are made to help a child who is struggling financially or has fallen on hard times. In other situations, clients make large gifts to their children to qualify for Medicaid or to avoid probate upon death or disability. Mary's story is all too common.
After Mary's husband Al died unexpectedly, she was surprised to discover there were some assets in Al's name not owned jointly with a survivorship feature. Mary was dismayed by the probate process and felt it was a "bunch of legal red tape" that delayed her from getting what was rightfully hers to begin with. To ensure her children did not have to endure a probate proceeding on her death, Mary contacted an attorney she found on the internet who prepared and filed a deed that transferred ownership of Mary's home to her daughter Susan.
Mary has lived in the same house for the past 30 years. It was titled in her name when it was purchased for $65,000 in 1985. Mary estimates the value of the house today to be close to $240,000. Mary then gifted the stock account she inherited from her father in 1972 to her son Bill which was also valued at close to $250,000. Finally, Mary added her two children to all three of her bank accounts which totaled close to $200,000. Mary hoped that by adding her two children as joint owners, either of them could sign checks and pay bills for her should she ever become ill or need help with her finances.
A few months later, Mary had a stroke and was admitted to Shady Acres Nursing Home for physical therapy. Mary's daughter Susan was happy to help her mom with her finances and made sure all of her bills were being paid from their joint account in a timely manner. Much to Mary's surprise, she received a call from the bank manager informing her that there were 10 checks which were returned for insufficient funds. Mary was more than surprised by this news as there should have been more than sufficient funds to pay the bills from her checking account. When Mary asked the bank manager why there was no money in her account he told her that her bank account had been attached by the IRS.
Mary and Susan were both stunned by this news as Mary always paid her taxes in a timely manner and to her knowledge had no outstanding tax liabilities. Susan immediately placed a call to her brother Bill to share what had happened. Upon hearing the news, Bill admitted that he had some outstanding income tax liabilities and he had been trying set up a payment plan with the IRS. Apparently, the IRS levied not only Bill's personal bank accounts, but also Mary's account because Bill was listed as a co-owner.
After several months, Mary, Bill, and Susan were able to convince the IRS to remove the levy on the account but only after significant disruption in Mary's finances. During this time, Susan and her husband Tom had been having some marital problems which worsened when Susan was spending less time at home and more time taking care of her mom. Susan's husband Tom filed for divorce and a lengthy divorce proceeding ensued.
As time progressed, it became apparent Mary's physical impairments would prevent her from returning to her home as she was not able to negotiate the steps in the split-level home. Mary decided it was best to sell the home and asked Susan to list it for sale. Within a few days, a full price offer was received that both Susan and her brother Bill immediately accepted. They were relieved as they would have funds from the sale of the home to continue to keep mom at Shady Acres without having to transfer her to a Medicaid facility.
Susan was surprised when she received a call from the title company that had conducted the title search as part of the sale of the property and was told that the Domestic Relations Court had placed a restraining order on all assets she had an ownership interest in from being transferred—including the house that had been gifted to her by her mom.
Susan contacted her divorce attorney and was told that it would take 60 to 90 days to file the appropriate paperwork with the Domestic Relations Court to exclude the house from the restraining order. In December, before the issue could be ruled on by the Domestic Relations Court, Mary had another stroke which took her life.
Susan then discovered the Domestic Relations Court had not only placed a restraining order on the house, but also on all three of the bank accounts that were title jointly with her mom and brother. With no liquidity to pay the funeral costs, Bill offered to sell the stock his mom gifted him the prior year so there would be immediate funds available to cover the funeral expenses as well as some home improvement expenses he was planning on making. After contacting the transfer agents, the stock was sold and a proceeds check was received.
Bill was surprised in February when he received a 1099 for the sale of the stock. Since the stock was gifted, the recipient of a gift takes the gift at the donor's original basis. As Mary had held these stocks for over 30 years before gifting them to Bill, the basis was very low resulting in unexpected capital gains taxes. Had Mary not gifted Bill the stock and instead kept it in her name with a Transfer on Death designation, there would have been no capital gains tax on the gain that occurred prior to Mary's death.
Susan was eventually able to clear all the legal hurdles of her divorce and was able to sell the house several months after her mom's death. She too was surprised that the sale of the house triggered capital gains tax liabilities for her as well. Her CPA correctly informed her that because she did not reside in the property, the personal residence exclusion for capital gains taxes did not apply.
Thus, the nearly $200,000 in appreciation that occurred over the thirty years Mary owned the house was unnecessarily subject to capital gains taxes. Had Mary kept the house in her name and added a Transfer on Death designation to her deed instead of gifting it to her daughter, the house would not have been attached during Susan's divorce, nor would there have been a capital gains tax when Susan sold the house.
Although Mary was able to successfully avoid the probate process by gifting assets during her lifetime, she gave up control of the assets, subjected them to the creditors and ex-spouses of her children, and caused them to be subject to unnecessary capital gains taxes. Gifting can be a powerful planning strategy when done correctly. But as Mary's story illustrates, gifting is not a strategy that should be taken without the assistance of qualified tax, legal, and financial professionals.
Scott A. Williams has been recognized by Avvo.com as Supurb rated and a Clients' Choice estate planning attorney, as seen below:
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