We've discussed the concept of "income shifting" many times in the past, but there seems to be ongoing confusion about gifting appreciated and depreciated stock and securities. So, this week we'll take a closer look at this nifty little technique. But before we get into the meat and potatoes of this issue, let's start with dessert by taking a few seconds to discuss the concept of income shifting for those of you who haven't yet been exposed to it, or have simply forgotten.

If you can find ways to move income that would be taxable to you (at your higher tax bracket) to your children, the entire family will benefit in the long run. Heck, it's not even just the kids that can get in on the action. You may have parents you support in one way or another. This means that their tax bracket is likely also lower than yours. So, if you can get some of your taxable income into their lower rates... well, you can see the positive impact for the family.

What you are doing is "shifting" your income from a higher bracket to a lower bracket. Is it legal? Sure, when done correctly. Does the IRS like it? Not necessarily, which is why the "kiddie tax" rules (among others) were put into place. But as long as you do all of the right things and stay within the law, Uncle Sammy is at your mercy for a change. And this technique works for property other than stocks and securities, but we'll focus on stocks this week.

What You Need To Know

Let's look this gift horse in the mouth, shall we? First of all, know that if you receive (or give) stocks as a gift, you must know (or provide) the following information:

• The donor's tax basis (a.k.a. cost basis) for the stock
  
• The fair market value of the stock at the date of the gift
  
• The amount of the gift tax, if any, paid by the donor on the appreciation of the property
  

Why do you need to know all of this? Because the recipient's (the person receiving the gift) tax basis in the gifted stock will depend on the donor's (the person making the gift) tax basis and the fair market value on the date of the gift.

What is the best way to provide this information? A simple letter from the donor to the recipient, with a copy of the original stock purchase confirmation attached, will do the trick. That'll give the recipient all of the information he or she needs to correctly compute any gain or loss on the shares when the stock is finally sold.

I can't tell you how many questions we see on the Motley Fool's Tax Strategies discussion board wondering how to obtain the basis of gifted stock... long after the original donor has passed away or after the brokerage statements on the original purchase have been destroyed. It's a real nightmare. So, since you're doing such a wonderful thing by making the gift, top it off by also providing the tax information that the recipient will eventually need.

Gifts of Appreciated Property

If the fair market value of the stock is more than the donor's basis at the time of the gift, then the recipient's basis is the same as the donor's basis. If the donor was required to pay gift tax, the recipient's basis is increased by the amount of gift tax paid that is attributable to that gift.

Here's an example: Dad buys 100 shares of ABC stock for $5 per share on January 15, 1997. Then Dad gives the stock to you as a gift on April 4, 2000. On the date of the gift, the stock is valued at $15 per share. You receive the stock and then sell it on April 8 for $15 per share. Your capital gains are long-term, even though you only held the stock for a few days. This is because, when you are given a stock gift, not only do you keep the donor's basis, but you also keep the donor's holding period. So this transaction would be reported on Schedule D using a purchase date of January 15, 1997, a sale date of April 8, 2000, and recognizing a long-term gain of $1,000.

But how does it work in the real world? Imagine that, for $20 per share, you bought 500 shares of XYZ stock. The stock is now worth $30 per share. You want to help Mom buy a motorcycle, take piano lessons, pay off a loan — whatever — so you give her 300 of the shares.

You have gifted stock worth $9,000 (300 times $30), so you're safely below the $10,000 annual gift tax exclusion limit (more on gift tax limits later). The basis of the shares in Mom's hands is $20 per share, your initial basis. If she turns around and sells the stock for $30, she will have a gain of $3,000 (300 times $10) that will be taxable to her.

If you are in the 28% tax bracket or higher, this $3,000 gain would likely cause you to pay taxes of $600 or more if you sell the stock. But if Mom is in the 15% bracket, she'll likely only pay about $300 in taxes on the same gain. Why? Because the capital gains tax rates are lower for folks in the 15% bracket than they are for folks in the 28% (or higher) brackets. So, it's pretty obvious — if you were planning to give Mom the $9,000 anyway, doing it by using appreciated stock only makes tax sense.

This is classic income shifting — and this type of shifting might be even more powerful when the new "super long-term" tax rates kick in. This type of income shifting also works well with children, but be aware of "kiddie tax" issues so you don't get caught in a trap.

Remember also that gifting assets to a minor child or other family member may work out well for both parties, but gifting must be viewed in the overall scope of a comprehensive estate plan. This isn't necessarily a "do-it-yourself" strategy. You may need assistance from a qualified estate tax pro if your gifts and/or estate are substantial.

Depending on the age and health of the donor, cash or high-basis securities may be the best things to gift while you're still alive and kicking, as higher bases are more advantageous for the recipients — because they'll keep your basis. Low-basis assets in the estate may be passed through to beneficiaries after your unfortunate demise. This takes advantage of the rule that lets the new basis be the fair market value of the securities on the day of inheritance (also known as a "step up" in basis on date of death).

Additionally, there are restrictions on gifts that you can make. Very simply, you are limited to a maximum of $10,000 per year per recipient before "gift tax" forms are required to be filed. If you're married, you and your spouse can each use the $10,000 maximum limitation to funnel a combined maximum of $20,000 to a specific individual per year. But the gift tax rules can get tricky, so make sure you have a firm understanding of them before you make any gifts.

Finally, don't confuse gifts (that are made to individuals) with charitable contributions (which are made to qualified charitable organizations — organizations given an official blessing by the IRS). They are two completely different concepts, so don't think that you are limited to a $10,000 contribution per year to your favorite religious organization or other charity.

Gifts of Depreciated Property

The rules above for appreciated property don't apply to depreciated property, so you really need a firm grasp of the differences.

If the fair market value of some stock (or other property) that you plan to give to someone is less than your tax basis in it at the time of the gift, your best strategy might be to simply sell the stock and recognize a loss, which you can use to offset other gains. Then take the proceeds and give them away instead of the stock. After you read the rules for gifting depreciated property, you'll more clearly understand why simply selling the stock, claiming the tax loss, and gifting cash might be the very best way to go.

If you want to give away stock that is now worth less than when you bought it, here's how it works. Let's say that you received shares of the Beehive Wig Co. (ticker: WHOAA) that have a fair market value of $8,000. The generous donor who gave them to you originally purchased the shares for $10,000. These two numbers are key. When you sell the shares, if they're worth more than the donor's basis ($10,000), the difference between the proceeds and the donor's basis is your gain. (Sell them for $11,000 and your gain is $1,000.)

On the other hand, when you sell the shares, if they're worth less than their fair market value when you received them ($8,000), the difference between the proceeds and the fair market value on receipt is your loss. (Sell them for $6,000 and your loss is $2,000.)

If, when you sell the shares, they're worth an amount between the fair market value when you received them and the donor's basis (in this case, between $8,000 and $10,000), you have neither a gain nor a loss.

Confusing? Just a little bit. Which is why, in many cases, simply selling the depreciated property is the best way to go from a valuation and eventual gain standpoint. Gifting depreciated property generally doesn't have the positive tax impact of gifting appreciated property. You can see that from the example above. So, think twice (or even three times) before making a gift of depreciated property.

A final thing to understand about gifts is that, once you give the stock or money, it's gone. You've lost control of it and cannot get it back.

Does gifting sound like something that might be worthwhile for you and your family? It's quite likely, so give it some thought — and additional study. You can read up on gift tax issues in IRS Publication 950.

If you like the way Roy Lewis simplifies confusing tax issues, check out his just-published book, The Motley Fool's Investment Tax Guide 2000: Smart Tax Strategies for Investors. This handy 360+ page guide covers just about every tax aspect of a typical Fool's life: investing, marriage, children, education, homes, home offices, retirement accounts, medical expenses, and much more.)

July 28, 2000

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