What is Upstream Gifting?
Upstream gifting is a tax strategy where a younger family member gifts an asset to an older relative. This is in contrast to the usual practice of passing wealth down to children or grandchildren (downstream gifting). Upstream gifting is a valuable strategy because it allows an appreciated asset to receive a step-up in cost basis when the older relative passes away, which can drastically reduce potential capital gains taxes when the asset is eventually sold.
What is a Step-Up in Cost Basis and How Does it Reduce Taxes?
Cost basis is essentially the original value of an asset for tax purposes. When the asset is sold, the difference between the sale price and the purchase price is used to calculate capital gains taxes. A step-up in cost basis means the asset’s original purchase price is adjusted to its current market value at the time of the owner’s death. This reduces the taxable gain when the asset is sold, because the difference between the sale price and the adjusted cost basis is much smaller.
This reset of the cost basis is the key to upstream gifting. The younger person gifts the asset to the older relative, and when the older relative passes away, the asset gets the step-up in basis. If the younger person inherits the asset, they benefit from dramatic capital gains tax savings when they eventually sell it.
Risks of Upstream Gifting and How We Address Them
While it can be valuable, upstream gifting does have some risks. A primary risk is that there’s no guarantee that the older person will pass the asset back to the younger person in their will (although it may be possible to stipulate that it be returned when the asset is gifted). Another risk is that there is a one-year period after the older person receives the asset during which the step-up in basis doesn’t apply, so if they pass away within a year of the transfer, it fails to achieve its goal.
To address these risks, instead of directly gifting the asset to the older person, it can be gifted to a trust where the older relative holds a general power of appointment. The power of appointment causes the asset to be considered part of the older person’s estate without them owning it, avoiding the risks related to losing ownership of the asset while obtaining the desired step-up in basis.
Final Thoughts
Upstream gifting presents a unique opportunity to reduce future tax burdens and transfer wealth efficiently across generations. Reach out to us to learn more.