Gifts are a part of everyday life. Birthdays, holidays and special occasions. Who doesn’t love getting gifts! This includes Uncle Sam. You may not be aware of this but when you make a gift you are engaging in a taxable transaction. This gift tax is an excise tax assessed on individuals who make a gift and it is based on the fair market value of the property transferred. Now just because you make a gift and it is taxable does not mean you will owe anything to Uncle Sam. I intend to give you the broad strokes of how the gift tax works so you know before you make a gift the potential tax consequences of your actions.
First things first. What is a gift? A gift is a transfer of property or an interest in property for less than fair market value. Simple enough. The gift tax applies to lifetime gifts, whereas the estate tax only applies to gifts made after death. While I am only discussing the gift tax today, it is important to point out that both types of gifts share what is called an applicable exclusion amount. The idea is that even though a gift may be subject to tax, the tax should only be paid if the total gifts, during life and post-mortem, exceed the exclusion amount, currently $5.45 million in 2016. If the total gifts exceed the applicable exclusion amount then it will be subject to tax. Right now the tax rates range from 18% to 40%, with the 40% bracket starting when taxable gifts made during life equal to or exceed $1 million dollars.
Before you start worrying that every gift you make is a hidden tax trap, not all gifts are treated as taxable gifts. For example, gifts to political organizations, gifts made directly to an education institution for tuition, gifts made to medical institutions on behalf of another and gifts that qualify for the annual exclusion are excluded from the IRS definition of gift and there is no requirement to report such gifts. Similarly, gifts to charity and gifts to spouses are allowed a deduction equal to the fair market value of the transfer (though there are some small exceptions) so while they are treated as taxable, in essence these gifts will not reduce the applicable exclusion amount.
Let me focus in a bit on the annual exclusion (this is different than the applicable exclusion) because it comes up quite frequently. When an individual makes a gift of a present interest, the gift will be treated as non-taxable up to the annual exclusion amount, currently $14,000 per recipient. Theoretically, this means an individual can gift an unlimited number of people $14,000 and he or she would never use a penny of their applicable exclusion. Now the rub here is that the gift must be of a present interest, which means the recipient has the right to use, possess and enjoy the property or income generated by the property without restriction (think gifts of cash or tangible property like a car or home).
Closely related to the annual exclusion is gift splitting. Married individuals can double up the annual exclusion by agreeing to treat a gift as being made by both individuals. So let’s use an example. Joan and her husband Earl are well off but Earl wasn’t as thrifty as Joan and as such most of the wealth is owned by her personally. Their son David has just graduated from school and they would like to give him a gift of some stocks Joan has bought over the years (worth $20,000). Now if the gift-splitting rules did not apply, if Joan makes a gift of the stock, her gift would be treated as part taxable and part non-taxable. The first $14,000 of the gift would be covered by the annual exclusion, leaving $6,000 to be treated as a taxable gift. Now if Earl consents to gift-splitting, the gift can be treated as if made equally by both parents (even though Joan owns 100% of the stock) which means that none of the gift will be taxable because the combined annual exclusion amount of $28,000 exceeds the fair market value of the stock. Used wisely, gift-splitting can be a very powerful tool in estate planning. Imagine if Joan and Earl want to move assets to their son over time; over the course of five years, the couple can gift David $140,000 worth of assets without incurring any gift tax consequences.
One of the big caveats of making a gift is that individuals need to consider the potential future income tax consequences of making a gift. The recipient receives the same basis in the gift as it had in the hands of the gift giver. So returning to our earlier example, if Janet gives her son, David, stock worth $20,000, which she purchased 15 years ago for $5,000, then if David later sells the stock his gain will be calculated using a basis of $5,000. Now if Janet had died, David’s basis would be $20,000 rather than $5,000 because assets received from an estate get a step up in basis. So with highly appreciated assets there may be a good reason to keep the asset in the estate rather than gifting it during life but that really depends on an individual’s circumstances.
So in summary, a gift tax is assessed on the fair market value of taxable gifts made during a person’s life. No tax will be due unless the taxable gifts, in total, exceed the applicable exclusion amount, currently $5.45 million. Not all gifts are taxable and so you need to check if certain exclusions apply, such as gifts that qualify for the annual exclusion. You also need to see if the gift qualifies for a deduction such as gifts to charity or to a spouse. Finally, remember that the applicable exclusion amount is shared with the estate tax and so taxable gifts will reduce the applicable exclusion amount available to the individual’s estate when he or she passes.
Whether or not planned gifting can benefit your estate depends on your particular circumstances, so if you have questions you should speak with an estate planning attorney or tax planner.