We've discussed "income shifting" many times, but gifting appreciated and depreciated stock and securities still confuses some folks.

Basically, 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. This technique works brilliantly even if you have parents you support in one way or another who are in a lower tax bracket than yours.

You are "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 the right things and stay within the law, Uncle Sam is at your mercy for a change.

This technique works for property other than stocks and securities, but we'll focus on stocks in this article.

What you need to know
If you receive (or give) stocks as a gift, you must know (or provide) the following information:

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

Why? Because the recipient's tax basis in the gifted stock will depend on the donor's tax basis and the fair market value on the date of the gift. A simple letter from the donor to the recipient, with a copy of the original stock purchase confirmation attached, will give the recipient all of the information needed 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 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, top off your wonderful gift by also providing the tax information the recipient will eventually need.

Gifts of appreciated property
At the time of the gift, if the fair market value of the stock is more than the donor's original cost basis, 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.

Example: Dad buys 100 shares of ABC stock for $5 per share and gives it to you as a gift several years later. On the date of the gift, the stock is valued at $15 per share. You sell it a few days later 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, you'd report this transaction on Schedule D using Dad's original purchase date, the sale date when you sold the stock (a few days after the gift), and recognizing a long-term gain of $1,000.

Using a gift to save taxes: You bought 500 shares of XYZ for $20 per share several years ago. The stock is now worth $30 per share. You want to help Mom out with a financial need, so you give her 300 of the shares.

You have gifted stock worth $9,000 (300 times $30), so you're safely below the $11,000 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 cost 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 27% tax bracket or higher, this $3,000 gain would likely cause you to pay taxes of $600 if you sell the stock (due to the 20% capital gains tax). But, if Mom is in the 15% bracket, she'll likely only pay, at most, $300 in taxes on the same gain, because the capital gains tax rates are lower for folks in the 15% bracket. If you held the stock for five years or longer, in fact, Mom will pay even less in capital gains taxes (8%) due to the superlong-term rates that went into effect on Jan. 1, 2001. So, if you were planning to give Mom the $9,000 anyway, doing it using appreciated stock only makes tax sense.

This is classic income shifting. 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 might 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 might 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 could be the best assets 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 can 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. Very simply, you are limited to a maximum of $11,000 per year, per recipient before you are required to file gift tax forms. If you're married, you and your spouse can each use the $11,000 maximum limitation per recipient.

Finally, don't confuse gifts (made to individuals) with charitable contributions (made to qualified charitable organizations). They are two completely different concepts, with different limitations. For more information, check out IRS Publication 526 (Adobe Acrobat required).

Gifts of depreciated property
The rules above for appreciated property don't apply to depreciated property.

If the fair market value of some stock (or other property) that you plan to give to someone is less than your cost 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.

To illustrate different scenarios, let's look at an example. You receive shares of the Beehive Wig Co. (ticker: WHOAA) that have a fair market value of $8,000. The generous donor 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.)

When you sell them, if they're worth less than the fair market value they had when you received them ($8,000), your loss is the difference between the proceeds from the sale and the fair market value when you received them. (In this example, if you sell them for $6,000, your loss is $2,000.)

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

Confusing? That's why gifting depreciated property generally doesn't have the positive tax impact of gifting appreciated property.  A final concept to understand is that, once you give the stock or money, it's gone. You've lost control of it and cannot get it back.

If gifting sounds like something that makes tax sense for you, read up on gift tax issues in IRS Publication 950 (Adobe Acrobat required).

Related Links:
IRS Publication 950
IRS Publication 526

If you like the way Roy Lewis simplifies confusing tax issues, check out his just-published book, The Motley Fool's Investment Tax Guide 2002: 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.)

May 31, 2002

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