When wealth passes between generations, it generally flows downstream, passing from an older generation to a younger one. Under certain circumstances, though, taking a detour in the other direction can help save you some money in taxes.
"Upstream" gifting is a wealth-transfer strategy whereby assets pass first to your parents or grandparents before ultimately going to your children (or other beneficiary), with the goal of lowering your estate's overall tax liability. To be clear, this isn't for every family or every asset. It works best for families in which the parents' generation has a large estate, while the grandparents have a much smaller one. Appropriate assets would be those that have accumulated a lot of value—like an old brokerage account with substantial built-in gains, or an investment property whose value has risen—and which could grow even more valuable in the future.
Could upstream gifting make sense for your family? Here's what to know.
Step right up
Upstream gifting relies on several features of the U.S. tax code:
- Estates/gifts are free from taxes up to the lifetime limit. In 2023, that's $25.84 million for a married couple, or $12.92 million for a single filer. (Upstream gifting strategies assume that the grandparent(s) have not, and will not, fully utilize their lifetime estate/gift and generations-skipping tax exemptions.)
- Heirs generally receive a step-up in cost basis on assets received as an inheritance. In other words, when a beneficiary inherits an appreciated asset their tax liability on all the accumulated capital gains effectively disappears. (Though, any future gains will have their own tax obligations.)
- Completed gifts, subject to the three-year claw back rule, are excluded from the donor's estate. That means you can effectively move major assets off your estate's books, which can reduce its future estate tax liability.
Here's how the upstream gifting strategy works:
- The parent transfers appreciated assets to their parent, using some of their lifetime estate/gift tax exemption amount. At this point, the cost basis of the gifted assets doesn't change. Why? In short, when assets are transferred during the donor's lifetime, they're considered a gift rather than an inheritance and so will retain their original cost basis (known as the carry-over basis, in contrast to the step-up basis for inheritances).
- The grandparent then designates their grandchildren as beneficiaries of those assets in their estate-planning documents. With luck, those assets will continue to appreciate while in the grandparents' possession, enlarging their estate without eating further into the parents' lifetime estate exclusion amount.
- When the grandparent passes away, the assets receive a step-up in cost basis to the fair market value as of the date of death. The assets are then transferred to the grandchildren with a stepped-up basis, effectively eliminating any capital gains that accumulated in the hands of both the parent and grandparent.
Upstream in action
This is a lot to take in, so an example might help.
A decade ago, Carla, 55, bought an income-producing commercial property for $1,000,000. It is now valued at $5,000,000 and generates $300,000 of income per year.
Carla, a recent window, has one son, George, 30, to whom she intends to leave her entire estate. Carla's mother passed away last year, and her father, Frank, 80, is in poor health requiring 24-hour professional care.
Given all this, Carla would like to reduce her projected estate tax liability, transfer the property to George as tax-efficiently as possible, and support Frank financially.
Using the upstream gifting strategy outlined above, Carla transfers the $5,000,000 property to Frank. This reduces her lifetime gift exemption by $5,000,000, lowers the overall value of her estate, and shifts $300,000 of taxable income off of her books. Once the transfer is complete, Frank modifies his estate plan to transfer the property to George upon his passing.
While Frank is alive, he receives the $300,000 in rental income, which he uses for his professional nursing care costs and to pay applicable income taxes.
Frank passes away four years later at age 84. The property, which was purchased for $1,000,000 but had a fair market value of $5,800,000 at the time of Frank's death, passes to George with a stepped-up cost basis. If George decides to sell the property in the future, his tax liability will be calculated using $5,800,000 as the cost basis.
To recap, Carla's upstream gifting strategy delivered the following benefits:
- A reduction of her estate by the value of the property and any future income it produced. Yes, the initial transfer would have eaten up $5,000,000 of her estate tax exclusion amount, but she also preserved more of that exclusion for the future by shifting $800,000 of subsequent appreciation, plus the income, to Frank's estate.
- Completely paying for Frank's nursing care during the last years of his life.
- The successful transfer of her property to George (via Frank) with a $5,800,000 cost basis. If she had transferred the property directly to George during her lifetime, the carry-over basis of $1,000,000 would have applied. Had she waited to pass it down with the rest of her estate upon her eventual passing, the appreciated value could have pushed the overall value of her estate over the estate tax exclusion amount.
Again, this kind of maneuver isn't for everyone, and there are other considerations to keep in mind:
- Once the grandparent owns the assets, they can do what they want with them. Agreeable family dynamics are crucial. In the worst-case scenario, a grandparent could decide they no longer want the transferred asset to pass to a grandchild.
- Assets owned by the grandparent become subject to the claims of their creditors. Be sure to think carefully about the grandparent's past, present, and possible future debt issues.
- Income generated by gifted assets can affect the grandparent's income taxes, Medicare premiums, and/or eligibility for government benefits. Talk with a CPA to determine how a gift of income-producing assets could affect the grandparent's taxes and overall financial situation.
- Future legislation could make upstream gifting strategies ineffective. There's no telling how long such strategies will be permitted, or whether the tax code could change.
As with all estate planning moves, be sure to talk with a CPA, estate planning attorney, and other professional advisors before making any major changes.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
The information and content provided herein is general in nature and is for informational purposes only. It is not intended, and should not be construed, as a specific recommendation, individualized tax, legal, or investment advice. Tax laws are subject to change, either prospectively or retroactively. Where specific advice is necessary or appropriate, individuals should contact their own professional tax and investment advisors or other professionals (CPA, Financial Planner, Investment Manager) to help answer questions about specific situations or needs prior to taking any action based upon this information.1023-3JH1