Gifts and Inheritances

There is often times confusion amongst taxpayers about the nature of gifts and inheritances, both for tax and basis purposes.  They can both be misconstrued as the same thing, but they are very different.  It is important to consult professional legal or tax advice regarding gifts and inheritances.  

Gifts

Gifts can be made by individuals to other individuals at their discretion.  Individuals can make gifts of up to $14,000 (2015) without reporting the gift.  Gifts over that amount require reporting on an annual gift tax return.  A recipients basis in the gift is typically the donor's adjusted basis (cost) in the gift when it is given.  There are special rules when the fair market value (FMV) of a gift is less than it's adjusted basis.  The recipient does not report the gift under any circumstance, unless it generates income or is sold for a gain/loss in the future.  

Transfers at death (inheritance)

Transfers received as a result of an individuals death (commonly known as an inheritance) are not taxable to the recipient, and their adjusted basis is typically the FMV of the assets on the date of death.  These assets only become taxable if they generate income or are sold at a gain/loss in the future.  If the transfer is made into a trust, the beneficiary might be required to report the income of the trust on their individual tax return.  

Application

In this scenario, let's say Sue has common stock with an adjusted basis of $10,000 and a current FMV of $13,000.  She gifts this stock to her son, Bob.  Sue does not file a gift tax return because the value of the gift is less than $14,000.  If Bob sells the stock once he receives it, he will have a capital gain of $3,000 because of the difference in the adjusted basis and the FMV.  

On the other hand, let's say Sue dies and Bob inherits the stock and immediately sells it.  He will have no capital gain or loss, because the FMV of the stock at the date of death will become his adjusted basis, which is also the same when he sells it.  

Taxpayers with assets they want to pass on should consult professional legal and tax advice in order to develop a gifting plan and a strong will to benefit their heirs or charitable organizations.  

All I Want for Christmas is Another Bulldozer

Last year I wrote a post discussing the tax benefit of buying a piece of equipment by 12/31.  As I predicted, the depreciation rules were not extended at the end of 2013, and taxpayers marched into 2014 with no provision for bonus depreciation and only $25,000 of Section 179 available.  But, thanks to Congress' call to action with the Tax Extenders bill signed into law December 19th, these great depreciation provisions are back for 2014.  

Although it might not be too late to ring the register on a new capital acquisition for 2014 if you both need and have the funds to purchase equipment or other assets, the following information can help determine the impact bonus and Section 179 depreciation will have on your tax situation for 2014.  

50% Bonus Depreciation

Bonus depreciation permits a taxpayer to expense 50% of the cost of an asset in the first year, plus normal depreciation on the remaining 50%.  Bonus depreciation can only be taken on assets that are new or being used in a new way in the hands of the user.  Simply, a new computer is eligible for bonus, but a used delivery truck that is purchased to be used as a delivery truck is not eligible for bonus.  Bonus is "automatic", meaning that in order to not take bonus on new assets you must classify the asset as "used" or elect out of bonus, which must be done by class life.  Bonus cannot be limited either by income or other factors, and bonus can put the taxpayer into a loss.

Section 179

For 2014, taxpayers can elect to expense 100% of an asset in 2014 using Section 179.  Taxpayer's can elect up to $500,000 of Section 179, but this amount is limited by taxable income and also by the amount of purchases eligible for Section 179 made during the year.  The asset can be new or used.  Section 179 cannot be utilized if the taxpayer does not have a profit, and any elected 179 that is unused is carried forward to future periods.  Once a taxpayer has made $2 million worth of eligible purchases, the amount of 179 available is reduced.  Unlike bonus depreciation, Section 179 is an election the taxpayer must make.  

Special considerations

One of the methods above is not necessarily better than the other, because all taxpayers have different motives.  But there are a few things to consider when accelerating depreciation:

  • Depreciation taken now cannot be taken later.  Taxpayers should consider their 2015 income and capital acquisition budget when determining how much accelerated depreciation to take in 2014.  
  • Cars are special, especially luxury cars, SUV's or trucks.  The amounts of bonus and 179 in some cases are limited.  
  • Cash flow planning is essential.  Utilize credit cards or short-term financing to purchase the asset before 12/31 and pay it off in January or in 2015.  
  • Don't purchase new equipment simply to avoid taxes.  If you were planning to purchase the new equipment then do it before 12/31 to take advantage of the depreciation rules.  But remember some deductions do not create a dollar-for-dollar reduction in taxes.

Beware the wash sale rules

December is a popular time for most investors to review their investment portfolio to see how their year turned out.  During this process, the investor might be encouraged to sell some of their investments by means of "capital gains harvesting".  Capital gains harvesting in simplest terms is the process of selling investments positions with a gain and positions with a loss at the same time in order to generate cash with no tax impact.  Investors will then take this cash and reinvest in other investments.  

However, due to an intricate tax rule that is becoming more well known, there is a possibility that what the investor reinvests their cash in could result in the loss generated by the initial sale being disallowed.  This is known as the "wash sale rule", and states that if an investor sells an investment at a loss and then purchases an identical investment within 30 days before or after the sale (60 days total), then the loss generated on the sale is disallowed and is added to the cost basis of the subsequent purchase.

For example, let's say I own 100 shares of ABC Inc and 100 shares of XYZ inc.  In December, my ABC stock has a $100 gain, and my XYZ stock has a $100 loss.  I decide to sell them both and generate cash, with a net capital gain of $0.  This is great because I now have cash to reinvest and I have no tax impact.  Then on January 3 of the following year, I hear on CNBC that XYZ has developed a new product that is going to make them much more profitable, so I go to my investment account and purchase 100 shares of XYZ again.  Because I sold XYZ at a loss in December, and then repurchased an identical security within 30 days, my $100 loss generated in December is disallowed for tax purposes, and instead the $100 is added to the cost basis of the shares I purchased in January.  

Fortunately, due to new reporting requirements for brokerages, wash sales will be automatically reported on a taxpayer's year-end Form 1099-B.  Investors should watch their investment transactions closely during December and January and be aware of any sales that might be subject to the wash sale rule.  

Additional information on sales of investments and wash sales can be found here at the IRS website.  

Year end to-do's

By now you have probably been bombarded with "10 Ways to Reduce Taxes" and "15 Investment Moves to Make Now" advertisements.  It is the end of the year, which means it is time to start thinking about taxes.  However, this does not have to be a cumbersome process and usually all "10 steps" don't apply to everyone.  Here are three key components of year-end tax planning to consider.  

Charitable contributions

For a charitable contribution to count for 2014, the check needs to be written and/or mailed, and credit card companies must acknowledge a charge on your statement by December 31 or earlier.   A good rule of thumb is to make sure you mail your check or ring up your credit card by the 28th to give the transaction the best chance of clearing by December 31.

Retirement plan distributions

Required Minimum Distributions (RMDs) from retirement plans must be made by December 31.  If you are required to take an RMD and neglect to do so by December 31, you could be subject to penalties.  

Investment vs. tax planning

Make sure to cross check your investment and tax planning with your investment advisor and your CPA.  Your investment advisor might encourage you to harvest some capital gains with losses in your investment portfolio, but since only up to $3,000 in capital losses can be reported on your tax return each year, make sure to run your investment plans by your CPA.  Also check any mutual fund holdings you have to see if they anticipate large capital gain distributions by year-end.