Senior Associate
Shareholder
Both the federal and Massachusetts estate taxes are based on the value of a person’s assets on his or her date of death. Both taxes provide an unlimited marital deduction, which means that all assets passing to a surviving spouse are not subject to the estate tax. Under the federal estate tax, each person also has an exemption which, for 2026, will be $15,000,000. A single person’s estate would have to exceed $15,000,000 before it would become subject to the federal estate tax. Likewise, a married couple could protect up to $30,000,000 with proper planning and a timely filed Form 706 federal estate tax return to elect portability for any unused exemption from the first spouse’s estate (DSUE). Consequently, the federal estate tax has become irrelevant for most people.
In contrast, the Massachusetts estate tax is still applicable to many estates. The threshold for an estate to be subject to the Massachusetts estate tax is $2,000,000. In 2023, Massachusetts updated its estate tax law, and the estate tax is now calculated on the amount which exceeds $2,000,000. Prior to the change, the entire estate had been taxable if it was greater than the estate tax exemption. The Massachusetts estate tax does not have a flat rate but imposes graduated rates which increase as the size of the estate increases. There are 21 brackets, with the highest tax bracket of 16% for the portion of an estate which exceeds $10,040,000.
In addition to the federal estate tax, there is also a federal gift tax. However, the federal exemption of $15,000,000 is also available to be applied to lifetime gifts, which means that a person could make gifts which total $15,000,000 and still not pay any federal gift tax. Nevertheless, it is important to remember that any gifts made during your lifetime will reduce the federal exemption available for your estate to use when you pass. The IRS allows a person to make gifts of up to $19,000 per recipient, each year, which are not subject to the gift tax, meaning gifts of less than $19,000 per calendar year will not reduce your lifetime federal estate and gift tax exemption. There is no Massachusetts gift tax.
The combination of a high federal gift and estate tax exemption and no Massachusetts gift tax means that a person could make gifts prior to his or her death to avoid or reduce the impact of the Massachusetts estate tax. To illustrate, say a father has an estate which has a total value of $5,000,000. Included in the $5,000,000 is the father’s home, which has a value of $1,000,000. The Massachusetts estate tax on an estate of $5,000,000 is $292,000. However, what if the father wishes to reduce the Massachusetts estate tax and determines that he could gift his house to his child, who will allow him to continue to live there. The father’s taxable estate would then be $4,000,000, and the Massachusetts estate tax would be $238,800, resulting in a tax savings of $53,200.
At first glance, this strategy seems to make a lot of sense. However, the above analysis has ignored the capital gain tax. The capital gain tax is a tax imposed on the sale of assets during our lifetime. When a person (donor) makes a gift of property to a donee, the donor’s cost basis in the property is also transferred to the donee. Thus, the child’s cost basis in the house would be the amount their father paid for the original purchase. However, when you receive an asset via inheritance, the basis of that inherited property is stepped up to the date-of-death value. The example below intends to illustrate the analysis when comparing the capital gain tax vs. the estate tax.
The father bought the home four decades ago for $100,000. The child has their own home, and after the father dies, the child intends to sell the house that belonged to the father. If the child sells the property after it was gifted to them for $1,000,000, the child will have a taxable gain of $900,000. The federal capital gain tax (20%) on $900,000 will be $180,000, and the Massachusetts capital gain tax (5%) will be $45,000, for a total of $225,000.
Because the property was gifted, the opportunity to step up the cost basis of the property was lost. As noted earlier, the tax law provides that when property is inherited and included in the decedent’s taxable estate, its cost basis gets stepped up to its fair market value on the decedent’s date of death. Returning to our example, if the father retained ownership of the house until he died, the child’s cost basis would be $1,000,000, and if the child sells it for $1,000,000, the child will have no capital gain and will not pay any capital gain tax. Even though the father’s estate did not owe any federal estate tax due to the $15,000,000 exemption, the house still gets a stepped-up cost basis for determining the federal capital gain tax. Gifting the property would result in capital gain taxes of $225,000, which exceeds the Massachusetts estate tax savings of $53,200 by $171,800. In this scenario, it would have been more tax-advantageous for the father to hold on to the house until his death and pay the Massachusetts estate tax regarding the house.
The analysis described above applies not only to real estate, but also to all assets subject to capital gain tax, such as stocks. There are many situations where it will still be prudent to gift assets to avoid the Massachusetts estate tax. For example, it may be prudent to gift an asset with a high-cost basis in relation to its value, so the step-up in basis is not as important. Additionally, if you imagine a scenario in which the father was giving the child a rental property or a vacation home, which the child has no intention of selling, then avoiding the Massachusetts estate tax may have a higher priority.
It is important to remember that before making a gift of any assets to avoid the Massachusetts estate tax, you should analyze the potential capital gain tax impact of that gift.