Besides donating appreciated securities to charity, another solution for avoiding highly taxed capital gains on these securities is to transfer the relevant assets to a family member in a lower tax bracket. The recipient might be able to sell and pay little or no tax on the sale.
Example: Grace Fulton invested $10,000 in ABC Corp. shares years ago. The shares are now worth $18,000; Grace fears the trading price of ABC will drop, so she’d like to sell the shares. However, Grace will face a significant tax bill if she takes an $8,000 long-term capital gain.
Therefore, Grace gives the shares to her son Eric, who sells them. Grace’s basis in the shares ($10,000) and her holding period (longer than a year) carry over to Eric, so he reports an $8,000 long-term capital gain. As long as Eric will owe less tax on a sale than Grace would have owed, the Fulton family will come out ahead.
This scenario can work in real life, but there are some issues to keep in mind. For one, gifts over $14,000 to any one recipient in 2014 may trigger the requirement to file a gift tax return. There may not be any gift tax owed, due to a $5.34 million lifetime gift tax exemption, but there can be paperwork requirements and the potential loss of estate tax benefits.
Moreover, the so-called kiddie tax limits the advantage of transferring assets to youngsters before a sale. In 2014, “kiddies” are taxed at their own tax rate on their first $2,000 of unearned income and generally owe little or no tax on the income. Beyond that $2,000, though, unearned income is taxed at the parent’s rate. Thus, if Eric Fulton has an $8,000 long-term gain from a stock sale and no other unearned income in 2014, $2,000 would get favorable tax treatment, but the other $6,000 would be taxed at his mother Grace’s rate.
The key question, then, relates to which youngsters are considered kiddies. Generally, that includes children 18 or younger. Kiddie tax status persists until age 24 for full-time students who provide less than half of their own support. Consequently, the strategy described in example 1 would offer little benefit if Eric is a college student this year, age 23, living nearby and spending most of his time going to class or studying.
If Eric is age 24, though, going to graduate school, the story can have a happier ending. Instead of selling the stock and paying tax on the gain, Grace can give the shares to Eric, who can make the sale this year. In 2014, a single taxpayer can have taxable income (after deductions) up to $36,900 and owe 0% on long-term capital gains. (The 0% tax rate for such taxpayers also applies to most stock dividend income.) As a result, Eric could keep all $18,000 from the stock sale and use the untaxed dollars to pay his school bills.
In 2014, the 0% rate on long-term capital gains also applies to married couples reporting up to $73,800 on a joint tax return. Therefore, transferring appreciated securities to family members with low to moderate income can be a substantial tax saver. Such gifts might be made to a married son or daughter who is buying a home, for example, or to retired parents who need financial help. However, as with all financial decisions, you should think carefully about all possible outcomes before giving away assets.