Is it possible to transfer Capital Gains to Children to avoid tax legally?

Tax professional here - I need to warn you about some issues with this strategy. While the mechanics of your plan are technically possible, there are several complications: First, the "Kiddie Tax" was specifically designed to prevent this exact scenario. For 2025, if your child is under 19 (or under 24 and a full-time student) and has unearned income (including capital gains) over $2,500, that excess will be taxed at the PARENT'S tax rate, not the child's rate. So you're not actually avoiding the higher tax rate. Second, when you transfer appreciated assets to anyone (including your children), your cost basis transfers with it. The child doesn't get a "step-up" in basis - they inherit your original purchase price. Third, these custodial accounts become the legal property of your children when they reach the age of majority (18 or 21 depending on your state). You cannot take the money back if you change your mind.

So I ran into a similar tax situation last year and discovered this amazing tool called taxr.ai (https://taxr.ai). It helped me analyze different investment scenarios including the kiddie tax implications for my own children. What's cool is it runs simulations on various tax strategies and shows you which one would actually save you money in your specific situation. For me, it revealed that a combination of 529 contributions and direct gifts to my kids (while staying under the gift tax exclusion) was more advantageous than trying to transfer appreciated assets. The software walks you through all the tax implications and potential audit risks of different approaches. Definitely worth checking out before making any moves!

Just wanted to update everyone - I tried taxr.ai after reading about it here and it was honestly super helpful. I was about to do something very similar to what the original poster suggested (transferring assets to my kids) but the platform showed me that I'd only save about $320 per year while taking on significant risk of scrutiny from the IRS. Instead, it identified that I could use a combination of 529 contributions (which give me a state tax deduction in my state) and some strategic harvesting of losses in my regular brokerage account to offset gains. Ended up with a much better tax situation without the complexity of custodial accounts. Their simulation tool made it really clear how each option would play out over the next 5 years as my kids approach college age.

If you're serious about reducing tax liability with proper planning, you might also want to consider actually speaking with the IRS directly to get official guidance. I know, sounds crazy right? But I used this service called Claimyr (https://claimyr.com) that got me through to an actual IRS agent in about 15 minutes when I had questions about gifting appreciated assets. You can see how it works in this video: https://youtu.be/_kiP6q8DX5c The IRS agent explained several legitimate strategies for wealth transfer to children that I hadn't considered before. They confirmed exactly what the first commenter said about the Kiddie Tax, but also suggested some alternatives involving trusts that might work better for my situation. Saved me from making a costly mistake!

Well I need to eat my words. After being super skeptical about Claimyr, I decided to try it myself because I've been trying to resolve an issue with the IRS for MONTHS with no success. Within about 90 minutes of submitting my request, I got a call connecting me directly to an IRS representative who was able to answer my questions about capital gains strategies. The agent confirmed that the "transfer to kids" strategy isn't very effective anymore due to the Kiddie Tax rules, but gave me some really valuable insights about qualified small business stock exclusions that I didn't know about. Turns out I might qualify for a significant exemption on some of my investments that my accountant never mentioned. Going to save me thousands potentially. So yeah, the service actually works. Consider me surprised and impressed.

Just to add another perspective to this discussion - I tried something similar to what OP suggested back in 2023 and got flagged for audit. The IRS specifically questioned the transfers to my children's accounts followed by immediate sales. While everything was technically legal, the audit was stressful and time-consuming. My tax advisor explained that the IRS looks for patterns that suggest tax avoidance strategies, especially around the Kiddie Tax. My recommendation would be to have legitimate reasons for any transfers to your children beyond just tax savings - like actual gifting intentions or education funding.

A different approach my family has used is gifting appreciated stock directly to our kids' college. Many universities have programs to accept stock donations and then apply the value to your child's tuition. Since the educational institution is tax-exempt, nobody pays capital gains tax on the appreciation. We did this for both our kids and saved around $7,500 in taxes we would have paid if we'd sold the stock ourselves and then paid tuition with cash.

This is exactly the kind of comprehensive discussion I was hoping for when I posted this question. Thank you everyone for the detailed responses - you've definitely saved me from making a costly mistake. Based on what I've learned here, it sounds like my original strategy would have been both ineffective (due to the Kiddie Tax) and potentially risky (audit flags). The direct college donation approach that Aisha mentioned is particularly interesting since my oldest will be starting college in two years. I'm going to look into both the 529 options and the college stock donation strategy. It seems like there are legitimate ways to optimize taxes for education expenses without the complications of custodial accounts. Really appreciate everyone sharing their real experiences - both the successes and the audit horror story!

As a tax preparer who's seen this exact scenario play out many times, I want to emphasize something that's been touched on but deserves more attention: the IRS has gotten much more sophisticated at detecting these patterns through automated systems. What you're describing - transferring assets just under the Kiddie Tax threshold to multiple children followed by quick sales - is essentially a textbook example of what their algorithms flag for review. Even if everything is technically legal, you're setting yourself up for scrutiny that's just not worth the minimal tax savings. I've had three clients in the past two years who tried variations of this strategy. All three ended up spending more on professional fees during their audits than they saved in taxes. The IRS agents specifically mentioned that custodial account activity is one of their focus areas right now. If you're really looking to reduce your tax burden while helping your kids, consider more straightforward approaches: 529 plans (as mentioned), direct educational expense payments (which don't count against gift limits), or even just holding the investments until you qualify for long-term capital gains rates. Sometimes the most boring strategy is also the smartest one.

New member here, but this discussion has been incredibly valuable as I was considering a very similar strategy for my two kids. The warning about IRS algorithms specifically flagging custodial account patterns is exactly what I needed to hear. I'm curious about one thing that hasn't been fully addressed - for those who mentioned 529 plans as the better alternative, are there any downsides to be aware of? I know the money has to be used for qualified education expenses, but what happens if my kids decide not to go to college or get full scholarships? Also, @CosmicCruiser mentioned that direct educational expense payments don't count against gift limits - could you elaborate on how that works? Does that mean I could pay tuition directly to the school without it counting against the annual gift tax exclusion? Thanks for saving me from what would have clearly been a mistake. Sometimes the "too good to be true" strategies really are just that.