An Appreciated Gift

MY NEPHEW GRADUATED from high school this past spring and starts college in the fall. Alex is fortunate to have received a full scholarship from his college of choice.

Wait, scratch that.

Alex isn’t fortunate. Rather, his diligence and academic success in high school have been rewarded.

While Alex needs no help paying for college, his notable accomplishment should still be recognized. We’d write him a check, but where’s the fun in that? How about a financial gift that’ll allow some one-on-one time that might spark an interest in sensible investing?

For instance, we could gift him some appreciated stock, which would also absolve ourselves of a future capital-gains tax burden. Or we could make a contribution to a Roth IRA up to the amount of his earned income and start him on a lifetime of tax-free growth. Problem is, we can’t put appreciated assets in an IRA, only cash. That means we can’t unload our appreciated assets and help Alex start a Roth.

Or can we?

It turns out we can, but there will be a few steps involved. Here are the steps and considerations we need to keep in mind:

• We’ll have Alex set up a taxable brokerage account in which to receive the gift, as well as a Roth IRA to be funded later. There are several firms that would be suitable, but since we’re at Fidelity Investments and understand its website and customer service, we’ll have him set up Fidelity accounts. Being at the same institution should make it easier to navigate the various steps.
• Once Alex has his brokerage account open, we’ll instruct Fidelity to make the transfer of an appreciated holding from my wife’s taxable brokerage account to Alex’s. This can be done in a few days.
• Once Alex has received the shares, he can sell and then invest some or all of the proceeds in his Roth IRA.

That sounds straightforward, but aren’t there tax considerations? Well, of course there are:

• On our end, each of us can gift up to $15,000 per recipient without needing to track this for future estate tax implications. No problem there.
• On the receiving end, Alex doesn’t need to report the gift as income. But what about the sale of the shares?

This is where it gets a little complicated. While we were aware of the rules on inherited stock, the IRS has different rules for gifted stock. Inherited stock currently gets a step up in cost basis to the value at the time of the original owner’s death or six months later, at the discretion of the estate. By contrast, with gifted shares, the recipient must pay tax on any capital gain tax based on the giver’s cost basis and holding period.

This is good news. If your shares are already long-term holdings when you give them, they’ll still be long-term holdings for recipients when they sell, even if they sell immediately. In the case of young adults, the news may be even better, as they may have so little income that they’ll pay capital gains tax at the 0% rate. That said, families need to be aware of both the college financial aid and kiddie tax implications of the gift.

The question of what to give is intriguing. Should it be the holding with which we can gift ourselves out of the largest capital gains exposure? The holding we’re ready to get rid of anyway, even if there’s not as much benefit from reduced gains exposure? The holding we’d recommend as the best choice for an 18-year-old, unless we’re suggesting he sell immediately?

In the end, we’re giving shares of an actively managed world stock fund. It has significant capital gains, so we give away that exposure. It’s somewhat tax-inefficient, so we improve our own portfolio in that way. Finally, while we’ll suggest Alex sell, and put two-thirds in a U.S. stock index fund and one-third in an international stock index fund, he might never get around to it. If that’s the case, the gifted fund is also fine to continue holding.

Aside from our case of rewarding a new high school graduate, the considerations here about gifting (and selling gifted) shares are applicable in other situations as well. Indeed, they might be even more important if giving to someone who’s already in the workforce making a significant income. In any case, if you gift shares, whether for a graduation, birthday, wedding, new child or some other reason, be sure to tell the recipient your cost basis in those shares, and to make clear why he or she needs that information.

Michael Perry is a former career Army officer and external affairs executive for a Fortune 100 company. In addition to personal finance and investing, his interests include reading, traveling, being outdoors, strength training and coaching, and cocktails. 

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