Can You Avoid Capital Gains by Gifting?

Individuals often transfer assets to family or friends and wonder about the tax implications, especially concerning capital gains. Gifting appreciated property has specific tax rules that differ from other asset transfers. Understanding these distinctions is important for financial planning, particularly regarding the interaction between gifting and capital gains tax.

Understanding Capital Gains and Basis

A capital gain is the profit from selling a capital asset, like stocks or real estate, when the selling price exceeds the asset’s basis. This basis is generally the original cost of acquiring the asset, adjusted for improvements. Calculating capital gains depends on establishing the correct basis.

Capital gains tax treatment varies by how long the asset was held. Gains from assets held for one year or less are short-term capital gains, taxed at ordinary income rates (10% to 37% for 2024). Profits from assets held over one year are long-term capital gains, typically taxed at preferential rates of 0%, 15%, or 20%, depending on income.

Gifting Appreciated Assets and Basis Transfer

Gifting an appreciated asset during one’s lifetime does not allow the donor to avoid capital gains tax on the appreciation that occurred before the gift. The donor does not realize a gain or loss at the time of the gift, so no capital gains tax is immediately triggered for them. Instead, tax implications shift to the recipient.

The recipient, also known as the donee, typically receives the asset with a “carryover basis.” This means they take on the donor’s original basis in the asset. If the recipient later sells the gifted asset, any capital gains are calculated using that original, lower basis from the donor, not the fair market value at the time of the gift. This rule ensures the appreciation from the donor’s ownership remains subject to capital gains tax when the asset is sold. For example, if a donor purchased stock for $100 and gifted it when it was worth $500, the recipient’s basis would be $100. If the recipient then sells the stock for $600, they realize a $500 capital gain.

A special “double basis” rule applies if the gifted asset’s fair market value at the time of the gift is less than the donor’s basis. If the recipient sells it for a loss, they use the fair market value. If they sell it for a gain, they use the donor’s original basis. For instance, if an asset with a donor’s basis of $1,000 is gifted when its fair market value is $800, and the recipient later sells it for $700, their loss is calculated from the $800 fair market value, resulting in a $100 loss. If they sold it for $1,100, the gain would be calculated from the original $1,000 donor basis, resulting in a $100 gain.

The recipient’s holding period generally includes the donor’s holding period. This combined holding period determines if the gain is short-term or long-term when the recipient sells the asset.

Gift Tax Rules

While gifting appreciated assets does not trigger capital gains tax for the donor, it can involve separate gift tax obligations. The federal gift tax applies to transfers of property by gift during the donor’s lifetime for which the donor does not receive full consideration. The donor is responsible for paying any gift tax due.

Each year, individuals can give a certain amount to any number of recipients without incurring gift tax or having to file a gift tax return. For 2024, this annual gift tax exclusion is $18,000 per recipient. Gifts below this threshold do not count against the donor’s lifetime exemption and do not require reporting to the Internal Revenue Service (IRS).

If a gift to an individual exceeds the annual exclusion amount, the donor must file Form 709, United States Gift Tax Return. This form reports gifts that exceed the annual exclusion and tracks the cumulative amount of taxable gifts made over a person’s lifetime. The value exceeding the annual exclusion reduces the donor’s lifetime gift tax exemption.

For 2024, the lifetime gift tax exemption is $13.61 million per individual. This exemption means most people will not owe federal gift tax during their lifetime, even if they make gifts exceeding the annual exclusion, because the excess amounts are subtracted from this lifetime exemption. Actual gift tax payment only occurs if total taxable gifts made over a lifetime surpass this cumulative exemption amount. Form 709 is due by April 15th of the year following the gift.

Gifting at Death vs. Gifting During Life

A significant distinction exists in tax treatment between assets gifted during a person’s life and those transferred upon death, particularly concerning capital gains basis. When an asset is inherited, its basis for the inheritor is “stepped up” to its fair market value on the date of the decedent’s death. This is known as the step-up in basis rule.

This step-up in basis can effectively eliminate capital gains tax on the appreciation that occurred during the decedent’s lifetime. If the inheritor sells the asset shortly after inheriting it, their new basis aligns closely with the selling price, resulting in little to no taxable gain. For example, if a parent bought stock for $100,000 and it was worth $1,000,000 at their death, the inheritor’s basis becomes $1,000,000, and if sold for that amount, no capital gain is realized.

This contrasts sharply with the carryover basis rule applied to assets gifted during the donor’s lifetime. The recipient of a lifetime gift takes the donor’s original basis, meaning all the appreciation from the donor’s purchase date remains subject to capital gains tax when the recipient eventually sells the asset. This fundamental difference means that from a capital gains perspective, it can often be more advantageous for beneficiaries to inherit highly appreciated assets rather than receiving them as lifetime gifts. The step-up in basis at death provides a tax benefit by resetting the cost basis, potentially saving beneficiaries a substantial amount in capital gains taxes.

Special Situations and Planning Considerations

Gifting a primary residence involves specific considerations. While an individual may qualify for a Section 121 capital gains exclusion when selling their own primary residence, gifting it means the recipient takes on the donor’s basis. This can expose the recipient to capital gains tax if they later sell the home and do not meet their own exclusion requirements, which typically involve owning and living in the home for at least two of the five years before the sale.

Gifting appreciated assets directly to a qualified charity can offer distinct tax advantages. Donors who contribute appreciated property held for more than one year to a public charity can avoid paying capital gains tax on the appreciation. They may also be eligible to claim a charitable deduction for the fair market value of the asset, subject to certain income limitations.

The rules surrounding gifting and capital gains are complex and depend on individual circumstances. Consulting with a qualified tax advisor is prudent before making significant gifts. A professional can provide personalized advice tailored to specific financial situations, helping individuals understand the full scope of tax implications and plan accordingly.