Gift may create income or gain to donor: think a gift results in no income or gain to the donor? Gifts of encumbered property, installment notes and certain stock options and net gifts may trigger donor income or capital gain.

• Author: Randall, Boyd C.

In the estate planning arena, tax professionals most often focus on transfer tax minimization. However, when a plan involves transfers of property in gift form, care should be taken that such transfers do not result in undesirable income tax consequences. This article examines situations in which gifts unexpectedly create income to a donor.

Noncash Gifts

Regs. Sec. 25.2512-8 defines a "gift" as a donor's voluntary transfer of cash or property without a receipt of valuable consideration in exchange. Because the donor receives no consideration, a gift does not usually create income or gain to him. However, a donor may receive partial consideration; such transactions are treated as a part-gift and part-sale, which may result in donor income or gain. Two of the most common part-gift and part-sale transactions are gifts of encumbered property and net gifts. Other gifts that may give rise to unexpected income to a donor include transfers of certain installment obligations and gifts of stock options. Tax advisers need to be aware of these types of gifts to ensure that both transfer and income taxes are minimized.

Encumbered Property

When encumbered property is transferred by gift to a donee, the determination of the transferor's potential income recognition depends on whether the donee is a charity. This distinction arises because different basis rules apply under Sec. 1011 to transfers of property to noncharities and charities.

Noncharitable Donees

When a taxpayer transfers property for less than its fair market value (FMV) other than in a business context, the transfer is a gift t6 the extent the FMV exceeds the proceeds the transferor received. (1) Thus, when a donor receives nothing in exchange for a transfer, the amount of the gift for transfer tax purposes is the property's FMV. (2) On the other hand, a gift of encumbered property is valued for gift tax purposes as the excess of the property's FMV at the time of the gift over any debt to which the property is subject. (3) The liability encumbering the property is deemed consideration paid to the transferor, resulting in a part-gift and part-sale. (4) Regs. Sec. 1.1001-1 (e) provides that on transfers of property to a noncharity that result in a part-gift and part-sale, the donor realizes income to the extent the proceeds received (i.e., the liability encumbering the property) exceed the donor's adjusted basis. (5)

Example 1: D transferred a parcel of land to her son, S. At the time of the transfer, the land's FMV was $300,000; D's adjusted basis was $150,000. The land is encumbered by a $175,000 mortgage.

The transfer of the encumbered land is treated as a part-gift and part-sale. D must recognize $25,000 of income ($175,000 (mortgage) -- $150,000 (adjusted basis)) on the gift, because the mortgage is treated as proceeds D received. The gift is $125,000 ($300,000 - $175,000).

Example 2: G created an irrevocable trust and transferred $50,000 to it. A trust provision gives G the power to change trust beneficiaries. The trust uses the $50,000 to acquire a 40% interest in a new limited liability company (LLC). In the first two years of operation, the trust's share of the LLC's losses are $55,000 and $30,000. G has sufficient basis to deduct these losses on his return. At the beginning of the LLC's third year of operations, G irrevocably renounces his power to change trust beneficiaries; at that time, the LLC has $200,000 in outstanding debt.

G's transfer of $50,000 to the trust was an incomplete gift under Regs. Sec. 25.2511-2(c), because G retained a power to change trust beneficiaries. Thus, the trust is treated as a grantor trust under Sec. 674(a). According to Regs. Sec. 25.2511-2(f), G's renunciation of his retained power at the beginning of the third year completes the transfer to the trust as a gift to the beneficiaries. At the time of the gift, G's LLC basis is $45,000, computed as follows:

Cash contribution $550,000 First-year loss (55,000) Second-year loss (30,000) Portion of LLC debt ($200,000 x 40%) 80,000 Basis $45,000 G's transfer is treated as a part-gift and part-sale. G's $80,000 share of the LLC'S debt is treated as an amount G received. Because G's basis in his LLC interest is only $45,000, G must report $35,000 income ($80,000 - $45,000) on the gift (i.e., his renunciation of the retained power). (6)

In summary, a donor's gift of encumbered property to a noncharity will result in donor income recognition when the liability on the gifted property exceeds the donor's basis. The above examples illustrate that both transfer and income tax consequences must be considered when contemplating such a gift.

Charitable Donees

Under Sec. 1011(b), a bargain sale to a charity is treated as a part-sale and part-gift. A gratuitous transfer of encumbered property to a charity is a bargain sale; the mortgage or other liability is treated by Regs. Sec. 1.1011-2(a)(3) as an amount the donor realized, even if the charity has not agreed to assume or pay the debt. However, unlike a transfer of encumbered property to a noncharity (in which the property's entire basis is measured against the transferred...