With the holiday season in full swing, folks generally feel more charitable. But did you realize that if you are too charitable to your loved ones, Uncle Sam may come knocking?
Yes, you can incur taxes for making certain gifts. While the overwhelming majority of taxpayers in the United States will never incur gift tax, folks still need to be aware of certain gift tax implications as part of their overall financial planning.
What is the gift tax, anyway?
If you make gifts to individuals above certain thresholds, you will be liable for a gift tax. This is completely separate from your personal income tax and involves filing a gift tax return. Be aware that the gift tax applies to the donor only, not the recipient.
This bears repeating, so here goes: The recipient is not liable for gift tax. If you receive a gift, what you do with it (such as dividends, capital gains, or rental activity) could incur tax, but there is no tax for receiving the gift itself.
The same general principle applies to inheritances. Be aware, though, that the IRS can seek reimbursement from heirs (up to the value of any inheritance received) if the estate fails to pay taxes owed before distributing assets.
A recipient may agree to pay any applicable gift tax under certain special arrangements. In the absence of such arrangements, the donor is liable.
What gifts count?
Completed gifts of money or property—real, personal, or intangible—to individuals besides your spouse are potentially subject to gift tax. A completed gift is one where you relinquish control over the property transferred and it is not subject to any contingencies (or any contingency has a possibility so remote as to be disregarded).
If you give property subject to a lien, the net value counts for gift tax purposes. For example, if you transfer real property subject to a mortgage, and the recipient is now liable for the mortgage, you are effectively only giving away the equity.
Partial gifts count, too. If you are the sole owner of a house, and add your child’s name to the deed, you are giving a 50% interest in the house to your child.
Gifts transferred in trust, or transferred indirectly, also count. If you set up an irrevocable trust as part of an asset protection strategy and transfer all your real estate holdings, bank accounts, and investment accounts to that trust, you have gifted the trust beneficiaries the value of the assets transferred. On the other hand, if you transfer assets into a revocable living trust, you have not made a completed gift since you maintain control over the assets.
What gifts are exempt?
Two of the largest categories of exemptions are marital and charitable. Because of the unlimited marital deduction for gift and estate tax purposes, gifts to your spouse during life or upon your death are tax-free. Similarly, there is an unlimited charitable deduction (for both gift and estate tax purposes) for contributions to organizations eligible to receive tax-deductible gifts. Giving large sums to your church and/or other public charities of your choice therefore has no gift tax implications.
Two more common categories are medical and educational gifts. If you cover medical or educational expenses for someone besides yourself, spouse, or dependents, those gifts would typically trigger gift tax implications. However, such gifts are fully exempt if paid directly to the medical provider or educational institution. Rather than writing a check to your grandchild for a large sum to cover the cost of a year of tuition, write the check directly to their school.
The educational exclusion only applies to tuition paid directly to the qualified school. Any amounts paid to or on behalf of someone for other purposes, such as books or room and board, do not count toward the educational exclusion. Similarly, the educational exclusion does not apply to contributions to qualified tuition programs (i.e., section 529 plans).
Similarly, gifts to political organizations and certain other tax-exempt organizations are excluded. See the instructions to Form 709 for full details on exempt gifts.
Do I have to track EVERY gift?
The largest gift tax exemption by far is the annual exclusion. In 2023, that amount was $17,000. It is indexed to inflation and will increase to $18,000 in 2024.
The annual exclusion applies to each recipient to whom you make gifts during the year. If you give $12,000 to your niece, and another $12,000 to your best friend, each of those gifts fall below the annual exclusion.
Also, remember that the annual exclusion is exactly that—annual. It is not a per-gift amount, but a per-year amount. If you give two gifts of $10,000 each to the same person, you have given them $20,000 in gifts during the year, so you exceed the annual exclusion. If you gave those same two $10,000 gifts in two different calendar years, they would each fall under the applicable annual exclusion.
Gifts subject to the annual exclusion generally are not reported on a gift tax return. If you give $17,000 to each of your nine grandchildren in 2023, and make no other gifts (besides perhaps charitable and educational gifts highlighted above), you do not have to file a gift tax return.
If you make gifts exceeding the annual exclusion, you must file a gift tax return, but the annual exclusion still applies. If you give $30,000 to your cousin, you would file a gift tax return to report the total gift (whether made in a lump sum or a series of smaller payments), deduct the $17,000 annual exclusion, and show a $13,000 net taxable gift.
What is gift splitting?
Gift splitting is an option available to married couples. If your spouse agrees, you can count any gift made by either of you as made one-half by you and one-half by your spouse. This would allow, for instance, that $30,000 gift to your cousin to be treated as if you gave your cousin $15,000 and your spouse gave your cousin $15,000. Because the annual exclusion is calculated on a per-person basis, neither of you would have a net taxable gift.
To split a gift, you must file a gift tax return (Form 709), even if the split results in no net taxable gifts. The IRS will presume that you made the entire gift unless you file a gift tax return showing the split.
You can split a gift whether you file your income tax return jointly or separately. Income tax—i.e., your “regular” tax—and gift tax are distinct matters.
Of course, you and your spouse could each simply write a separate $15,000 check or make a unique $15,000 transfer. In that instance, each spouse would be treated as having made a separate gift, so no gift tax return to report a split gift is necessary.
What happens if I still have a taxable gift?
If you split gifts, or have taxable gifts after applying the annual exclusion to each recipient, you must file a gift tax return. That does not mean that you will actually owe gift tax. So few people end up owing gift tax that I will not even bother discussing the gift tax rates.
How is that possible? Enter the unified credit. The unified credit is the total amount of taxable gifts you can give during your lifetime or at death before you incur gift or estate tax. The amount for 2023 is $12.92 million. It is indexed to inflation, so it will increase to $13.61 million for 2024.
Assume that you own unencumbered real estate that is worth $5 million. You transfer it into an irrevocable trust on December 1, 2023. Your two children are the beneficiaries of that trust, so you are treated as having given $2.5 million to each child. You thus have two taxable gifts of $2.5 million each, so $5 million total taxable gifts. (If you made no other gifts to your children in 2023, you would subtract the annual exclusion and have a slightly lower taxable gift, but we will skip that step here for ease of illustration.) Because you made taxable gifts, you file a gift tax return for 2023. Further assume that this is the first time you have ever made a taxable gift. On your gift tax return, you will apply $5 million of your available unified credit against the amount of your taxable gifts, so you end up owing no gift tax.
Notice the subtle distinction between making taxable gifts and owing gift tax!
Now assume that you die in 2024 having made no additional taxable gifts. Because of the unified credit, your estate will incur no estate tax unless you leave more than $8.61 million—your $13.61 million unified credit for 2024 minus the $5 million in previous credit used—to non-exempt heirs. (Gifts to spouses and recognized charities are still exempt, and do not count against the unified credit!)
The most common place I see this play out is when parents transfer property to their children and/or grandchildren. This generally results in a taxable gift, triggering a gift tax return filing requirement, but no gift taxes owed because of the unified credit’s high threshold of lifetime gifts allowed.
What is the bottom line?
You might need to file a gift tax return at some point. I assist a handful of folks with this every year. Unless you anticipate giving away more than $13 million combined during your lifetime and at death, though, you will not need to worry about paying any gift or estate tax. Even then, we can devise strategies to minimize, delay, or even avoid it altogether.
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