Using Kids for Tax Benefits


Reader QuestionCould you speak to the tax consequences of a minor’s earnings? My two-year-old son recently inherited $5,000 for which I opened an investment account. I earn a six-figure income. Will any dividends and other earnings that he accrues be taxed in my bracket, or in his? If the latter, this seems like a perfectly good college fund, without the risk of a penalty should he ultimately not pursue higher education. M.S.
Answer: The Kiddie Tax was enacted under the 1986 Tax Reform Act to dissuade wealthy parents from shifting income from their high tax bracket to a child’s low tax bracket by gifting investment assets to the child. For 2013 and 2014, a child who is under the age of eighteen during the calendar year can have unearned income (interest, dividends, rent, etc.) of up to $2,000. John West, CPA, partner at Sellers Richardson Holman & West of Birmingham, Alabama added,The kiddie tax also applies to children under age 24 who are full time students and who do not provide half of their support through earned income”. 
Unearned income above this threshold must be reported on the parent’s tax return with taxes paid at their, presumably, higher tax rate. Further, for 2013 and 2014, the first $1,000 of the child’s unearned income is not subject to federal income taxes. The next $1,000 is taxed at 10%. It’s very unlikely that your child’s money will earn above these amounts in the next several years. 
Tip:  High tax bracket taxpayers should consider transferring income producing assets to minor children to take advantage of the children’s lower tax bracket. For folks whose children have assets that may earn above the $2,000 threshold, consider investing the money in a 529 college savings plan. Once in the plan, the money grows tax deferred and if the funds are later used for qualified education expenses, withdrawals are tax free. If money is withdrawn for other than qualified education expenses, the gains are subject to ordinary income taxes plus a ten percent federal penalty. Assuming that event occurred after the child reaches age eighteen, the kiddie tax would not apply and the taxes would be reported on the child’s tax return…presumably at a lower tax rate than the parent. Tax deferred growth for a decade or more may produce a higher investment value even after the taxes and penalty are paid. 
Reader QuestionI am 63 years old and have owned rental real estate for 30 years. What is the best way to liquidate it leaving the largest possible amount for my children? If I just let them inherit the houses at my death do they get it at an appreciated basis or is the tax liability the same as if I cash out and leave them cash? V.F.
Answer: If your children inherit the real estate, they will receive a ‘step-up’ in tax basis…meaning they could sell it the next day and owe no income taxes. Obviously, if you sell you’ll owe capital gains taxes which under the current law are potentially much higher (and more complicated) than in the past. In the ‘good old days’, the maximum federal rate on long-term capital gains was 15%. Under current law if your Adjusted Gross Income (AGI) exceeds $250,000 for joint filers ($200,000 for single filers), you also may be subject to the additional Obamacare tax of 3.8%. In addition, if your AGI exceeds $450,000 ($400,000 for single filers), the federal capital gains rate jumps to 20% bringing your total tax rate to a potential 23.8%. John West, CPA, adds, “Depreciable real estate (rental property) is subject to a 25% tax rate on the long-term capital gain attributable to prior depreciation – so the potential tax savings from inheritance and step-up in basis are greater on real property than from stocks”.
From a purely tax perspective, your best move is to hold the properties until death, allow your children to get the step-up in tax basis; then sell if they choose to do so. 
Tip: An alternative to this strategy is to use a 1031 ‘like-kind’ exchange (tax-free exchange) to roll up your multiple properties into a single property that requires minimum management. An example of this might be a Dollar General store which is typically purchased on a ‘triple-net-lease’ basis (they are responsible for property taxes, insurance and repairs) with a long-term rental agreement.
Depending on your children’s abilities, sometimes it’s better to go ahead; sell now; pay the taxes and invest in assets that don’t require the attention to detail associated with rental properties.