Gifting appreciated assets: Understanding an often overlooked tax benefit

It is well understood that retaining appreciated assets until death generally produces a more favorable income tax result for heirs. That advantage stems from the step-up in cost basis at death that resets to fair market value. This typically allows the beneficiary to sell these assets with little or no capital gains tax.

Yet for many high-net-worth families, retaining appreciated assets until death may not always be the best strategy. Whether driven by estate tax considerations, or the desire to support family members during life, gifting is often an important part of a broader wealth planning strategy.

When lifetime gifting makes strategic sense

Common reasons you may choose to make lifetime gifts include:

• Managing estate tax exposure: Lifetime gifts and transfers at death are currently measured against the same federal exemption. If the value of your estate exceeds the applicable threshold the excess may be subject to federal estate tax at death. Lifetime transfers can help reduce the size of your ultimate taxable estate by removing future appreciation from being subject to estate tax on the federal side and can also serve to reduce state estate taxation where there would otherwise be exposure.
• Planning around liquidity events or business transitions: In many cases, ownership transitions, such as passing a family business to the next generation or preparing for a sale, are preferrable during your lifetime. Gifting interests in advance can help facilitate that transition before a key business owner’s death, while also managing estate tax implications.
• Addressing real-time family needs: Waiting until death may not align with your family’s priorities. Whether it’s funding education, helping with a home purchase, or supporting a new business, lifetime gifts allow you to provide resources when they can have the greatest impact, and provide you with the opportunity to see your gifts in action.
• Leveraging trust structures for multigenerational planning: Many advanced planning strategies are designed to ultimately transfer wealth out of the estate while taking advantage of tax law provisions which shift income tax burdens (intentionally defective grantor trusts) or permit retained interests (such as grantor retained annuity trusts and qualified personal residence trusts). These strategies rely on lifetime gifting to be effective.

In these scenarios, gifting is not just a tax decision, it’s a strategic one.

An overlooked offset: How gift tax may reduce future capital gains tax

A fundamental trade-off in lifetime gifting is the loss of the step-up in basis, resulting in the carryover of built-in gain to the recipient. There is, however, a lesser-known rule that may help offset some of that impact.

When a gift exceeds your available exemption and gift tax is paid, a portion of that tax, specifically the part attributable to the asset’s appreciation can be added to the recipient’s cost basis. In other words, part of the tax paid today can help reduce the capital gains tax exposure your beneficiaries may face in the future.

While this adjustment doesn’t replicate the full step-up in basis available at death, it can meaningfully reduce capital gains tax on assets you gift during your lifetime and improve overall outcomes when lifetime gifting is already part of the plan.

The goal:

• Less tax owed when assets are eventually sold
• More after-tax wealth preserved within your family

Example: How this may work in practice

Consider a simplified scenario:

You gift shares of stock worth $1 million to your child. Originally purchased for $100,000, the shares carry $900,000 of built-in gain. If no gift tax is paid, your child will receive the shares with your original cost basis. Meaning, a sale at $1 million would then result in capital gains tax (at their rate) on the full $900,000 gain.

Now assume you’ve already used your lifetime exemption and must pay gift tax on the transfer. At a 40% tax rate, the $1 million gift results in $400,000 of gift tax.

Now that you have paid gift tax after transferring assets or stock to your child, the Internal Revenue Code allows a portion of that gift tax to be added to your child’s basis. The adjustment is proportional to the asset’s appreciation. In this case, 90% of the gift’s value represents gain ($900,000 ÷ $1,000,000), so 90% of the gift tax paid can be applied to the basis.

• Gift tax paid: $400,000
• Portion attributable to appreciation: 90%
• Basis adjustment: $360,000

This increases your child’s cost basis from $100,000 to $460,000. If they sell the shares for $1 million, their taxable gain is reduced to $540,000, rather than $900,000.

The result: a portion of the tax paid up front effectively reduces the tax owed later. This is a meaningful difference that comes from understanding how gift tax interacts with cost basis.

In addition, since the liability for gift tax is on the donor, in most cases your taxable estate will be reduced by the amount of gift taxes paid if the gift occurred more than three years before your date of death.

How gift taxes paid can reduce capital gains tax for gift recipients

* For illustrative purposes only. This example assumes the highest federal long-term capital gains tax rate of 20% plus the 3.8% Net Investment Income Tax (NIIT), resulting in a combined tax rate of 23.8%. Actual tax rates may vary based on income level and state of residence.

Why this adjustment is often missed and how to preserve it

Although this rule can create meaningful tax savings, it is often overlooked in practice. In many cases, families have already paid gift tax as part of their planning, but never fully realize the benefit, not because the strategy was ineffective, but because the follow-through was incomplete.

The adjustment to cost basis is not automatic. It must be calculated, documented and carried forward over time. Without that coordination, the information can be lost, particularly when assets are held in trust, managed across multiple advisors or transferred across generations.

The result is simple: a benefit you have already paid for may never be realized.

Capturing that value requires a coordinated approach. The portion of gift tax attributable to appreciation must be properly calculated and reflected in the asset’s adjusted cost basis, then tracked by the gift recipient, with documentation preserved alongside gift tax filings so proper basis can be applied when assets are ultimately sold. A timely filed Form 709 that adequately discloses the gift is also important. It generally starts the three-year period for the IRS to challenge the reported value of the gift. Without adequate disclosure, that period may remain open indefinitely.

Just as importantly, this information must be clearly communicated across your advisory team and to future owners of the asset, including trustees if transferred to a trust. Without that continuity, even well-designed planning strategies can lose part of their intended benefit.

The subtle trade-offs that shape better wealth transfer

Every wealth transfer strategy involves trade-offs. The key is understanding them fully. If you have made or are considering taxable gifts now, discussing this basis adjustment opportunity with your advisors can lead to more informed planning decisions.

 

 

 

 

Disclaimers:

In the example:

• Fair market value of the asset: $1,000,000

• Original cost basis: $100,000

• Built-in gain: $900,000

The built-in gain represents 90% of the asset’s value ($900,000 ÷ $1,000,000). As a result, 90% of the gift tax paid is attributable to that appreciation and may be added to the recipient’s cost basis.

• Gift tax paid: $400,000

• Portion added to cost basis (90%): $360,000

This increases the recipient’s cost basis from $100,000 to $460,000.

• Adjusted cost basis: $460,000

• Taxable gain upon sale: $540,000 ($1,000,000 − $460,000)

At a 23.8% capital gains tax rate, this results in:

• Tax without adjustment: $214,200

• Tax with adjustment: $128,520

This example is for illustrative purposes only. Actual calculations may vary based on specific facts, tax rates, and applicable rules. Please refer to 26 U.S.C. § 1015(d)(6)(A) for additional information. Note: Gift tax and capital gains tax are separate taxes that apply at different times and to different taxpayers. Gift tax is a transfer tax paid by the donor at the time of a taxable gift and is based on the asset’s fair market value. Capital gains tax is an income tax paid by the recipient only if and when the asset is later sold, based on the difference between the sale price and the asset’s adjusted cost basis.