Alvina Lo is the Chief Wealth Strategist at Wilmington Trust.
Wealth begets wealth. While there are many examples of individuals who become millionaires through sheer hard work and determination, the vast majority of the wealthiest among us have had some help along the way.
Having a strong financial head start is often a necessary steppingstone to success. Therefore, emphasis should be placed on understanding the importance of building generational wealth—especially for historically underrepresented communities that have struggled to maintain wealth.
Wealth parity in the United States will always evade us unless people get in a better position to pass wealth from generation to generation, regardless of ethnicity or background.
A Common Denominator
As a first-generation Asian American, I’ve experienced the complexities of wealth creation firsthand.
Growing up in an immigrant household and later advising private wealth clients as a trusts and estates attorney, I understand the significance of financial literacy in concepts such as trusts, tax planning and asset protection.
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In my years as an advisor and executive in private wealth management firms, I’ve met thousands of successful individuals across the wealth continuum—from the affluent, to high net worth and billionaires. Whether they’ve generated their wealth as highly compensated professionals or as business owners and entrepreneurs, the vast majority of them started with a small, yet significant, financial stake—be it seed money, family connections or a minor loan. This provided an initial spark and financial security that allowed those hardworking individuals to dream big and to take calculated risks.
This initial advantage underscores the necessity of not just hard work, but also the value of a financial safety net and access to knowledge and resources to grow, protect and pass on wealth.
Home Sweet Home?
For most Americans, their home represents their most significant asset heading into retirement. Yet, transferring this asset efficiently to the next generation remains a challenge for many and represents a significant opportunity to give the next generation a much-needed head start.
Many people when they retire downsize or sell their home and choose to rent. While that may make sense practically, it may not be the most tax-efficient plan from a multigenerational standpoint.
Instead of selling their home and paying the associated capital gains tax, a parent may consider holding on to it and, instead, bequeath the real estate to their children upon their death. This is because the parent’s assets, including the home, get a step up in basis at death. This way, a child would inherit the property at a cost basis equal to the fair market value so that when/if they sell it, there would be minimal capital gains tax due.
Before using this strategy, there are a few considerations.
The first is in the homeowner tax exclusion found in Section 121 of the Internal Revenue Code. This provision allows homeowners to exempt up to $250,000 of gains ($500,000 for married couples filing jointly) on the sale of their primary residence.
At first glance, it may seem that this exemption would be sufficient, as there will likely be no tax due if parents were to sell the home. However, keep in mind that this exemption is limited only to primary residences and comes with certain ownership and timing requirements.
Also, for those who have owned a home for a long time, the appreciation may exceed the above-mentioned threshold, especially with today’s heightened real estate values. If parents are financially able to keep their home while either renting or purchasing a smaller apartment in retirement, it may be a smarter multigenerational strategy to view it as an investment that will receive the benefit of the step up in basis.
Alternatively, if parents have other assets, retirement accounts for example, it may make more sense to spend down those assets, even if it means depleting them, to preserve the home until death (remember—retirement accounts do not get a step up in basis). In some cases, it may even make sense for children to help the parents financially so that the family, from a multigenerational perspective, can preserve that step up.
Risk Of Transfers
Very often I also see that, for ease and convenience, parents transfer properties to their children while the parents are still alive. Parents either add a child’s name on the deed or transfer the property to them outright.
The missing opportunity here is in the understanding of the cost-basis rule.
When a parent transfers a property while he or she is alive, it is considered a gift and that child, as recipients of a gift, will inherit the parent’s cost-basis. If the child does not, in turn, qualify for the homeowner exemption (or the value has exceeded the threshold amount by the time they sell), they will end up with a tax bill that otherwise could be mitigated if the parent were to pass the home to them after their death.
As with all financial planning decisions, there will be other factors at play. In this case, considerations should also be given to relevant estate taxes or elder law concerns. The above is a specific example to highlight the importance of viewing assets from a multigenerational and after-tax perspective.
Building wealth that can close the wealth gap is like building skyscrapers: You need a strong foundation, and each generation must build upon previous achievements without having to start from scratch or spend energy fixing cracks.
Viewing assets from a multigenerational perspective and understanding how to utilize smart tax planning tools are critical to preserving and passing on wealth to future generations. Strategic and well-informed wealth planning is necessary to establish an enduring and beneficial legacy for all.
This article is for general information only and is not intended as an offer or solicitation for the sale of any financial product, service or other professional advice. Wilmington Trust does not provide tax, legal or accounting advice. Professional advice always requires consideration of individual circ*mstances. Wilmington Trust is a registered service mark used in connection with various fiduciary and non-fiduciary services offered by certain subsidiaries of M&T Bank Corporation.
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