“A boat is a hole in the water into which one pours money.” 1 One of my sons recently celebrated his 14th birthday. To celebrate his own day of birth, my son cut himself a piece of birthday cake, the size of which could have fed a small village, and consumed the entire piece in one sitting. We have adjusted our grocery budget accordingly.
In the estate planning and gift planning space, certain gifts made to a charity or a family member are sometimes called “gifts that eat.” Once a child becomes the owner of a gifted asset, the gift will “eat into” the child’s personal expense budget. In this month’s update, I briefly summarize the legal and tax issues of “follow-on” family gifting—that is, gifts made to support previous gifts given.
Legal Rules
Any transfers made to an adult child should be clearly identified as a loan or as a gift. If the transfer is characterized as a loan, the loan is treated like any other asset of the parents after death. The loan is an asset that could be allocated to the share of the debtor-child, then forgiven. In contrast, a gift not documented as an “advancement” must be ignored in making an equal division at death. Therefore, clients who want to equalize unequal lifetime gifts should have an “advancement list” in place. This list directs that certain lifetime gifts be incorporated into a plan for equal division among children following death.
Tax Rules
- If the transfers are characterized as a loan, the children should sign a loan agreement. The parents can charge whatever interest rate, including a 0% interest rate, that is agreed upon by the family. However, if the loan is substantial,2 the IRS will impose for income tax purposes a minimum interest rate on an intra-family loan. This minimum interest rate is known as the “AFR rate,” and is set monthly by the IRS. The current AFR rates are about 5%.3 Regardless of whether the parents receive the interest payments from the child, the parents must report on their personal tax returns the interest payments as if received.
- If the transfers are characterized as a gift, the child should not report the transfer as taxable income. If the value of the gift is above $18,000 in value (or, $36,000 if married), the parents must file a gift tax return. The gift tax return would need to be filed to report the use of “unified credit” against federal gift and estate taxes. Many follow-on lifetime gifts are below $18,000 in cumulative value (or, $36,000 if married), in which case no gift tax returns need to be filed.4
Additional Considerations for Real Estate
As reported in the Wall Street Journal and elsewhere, it’s never been costlier to own a residential property. Many of our clients are therefore financially assisting children with the carrying costs of a home or cabin. While the above-referenced rules apply to any lifetime transfers to children, these rules are most commonly arising in the context of real estate ownership. Two additional considerations worth noting:
- Liability for Costs. If a home or cabin has already been transferred to the children during lifetime, and if the parents have estate tax concerns at death, all legal attributes of ownership should be followed. Property taxes, utilities, and insurance records must be changed to reflect that the child (or children) are responsible, not the parents. Of course, parents could gift amounts to pay these carrying costs.
- Post-Death Cabin Expense Fund: To achieve the benefits of follow-on gifting after their deaths, the estate plan of mom and dad could direct the creation of a “Cabin Expense Fund Trust” following death. This fund would receive cash following the second death to pay cabin or residence carrying costs. This Expense Fund effectively continues mom and dad’s “follow on” gifting strategy.
This weekend, we will be visiting the family lake home, where additional sweat and financial equity will be poured into various cabin projects. Along similar lines, much food will be poured into my son’s hollow leg. Regardless of what you’ll be doing this Memorial Day weekend, I hope you and your family have a great weekend. As always, my colleagues and I at Veritage Law would be glad to speak with you or your clients about gifting strategies.
1 Ancient Minnesota proverb uttered by boat sellers.
2 If the loan amount is $10,000 or less, no interest needs to be reported. If the loan amount is between $10,000 and $100,000, the interest rate is the lower of (i) the AFR rate and (ii) the child’s net investment income for the year. IRC §7872(d).
3 The rate will depend on whether the loan is a short-term loan (up to 3 year loan), mid-term loan (3 to 9 years), or long-term loan (longer than 9 years). For May of 2024, interest rates are as follows: Short-term: 4.97%; Mid Term: 4.42%; and Long Term: 4.55%.
4 The federal unified credit is currently $13,610,000, such that in most cases of asset transfers, no gift tax would be due. Rather, the gift of the property would reduce your remaining “unified credit” against federal gift and estate taxes.