Why it pays to understand the federal gift tax law
If you give people a lot of money or property, you might have to pay a federal gift tax. But most gifts are not subject to the gift tax. For instance, you can give up to the annual exclusion amount ($13,000 in 2010 and 2011) to any number of people every year, without facing any gift taxes. Recipients never owe income tax on the gifts.
And you can give a total of up to $1 million in gifts - 5 million starting in 2011- that exceed the annual limit in your lifetime, before you start owing the gift tax. If you give $15,000 each to ten people in 2010, for example, you'd use up $20,000 of your $1 million lifetime tax-free limit—ten times the $2,000 by which your $15,000 gifts exceed the $13,000 per-person annual gift-free amount for 2010.
The general theory behind the gift tax
The federal gift tax exists for one reason: to prevent citizens from avoiding the federal estate tax by giving away their money before they die.
The gift tax is perhaps the most misunderstood of all taxes. When it comes into play, this tax is owed by the giver of the gift, not the recipient. You probably have never paid it and probably will never have to. The law completely ignores gifts of up to $13,000 per person, per year, that you give to any number of individuals. (You and your spouse together can give up to $26,000 per person, per year to any number of individuals.)
If you have 1,000 friends on whom you wish to bestow $13,000 each, you can give away $13 million a year without even having to fill out a federal gift-tax form. That $13 million would be out of your estate for good. But if you made the $13 million in bequests via your will, the money would be part of your taxable estate and, depending on when you died, might trigger a large tax bill.
The interplay between the gift tax and the estate tax
Your estate is the total value of all of your assets, less any debts, at the time you die. For most people, no estate tax applies in 2010. Under the recently enacted tax relief act for 2010, if you died in 2010, you have the option of applying the rules for 2010 or the new rules for 2011 which will tax estates over 5 million at rates as high as 35%. That 5 million is an exclusion meaning the first 5 million of your estate does not get taxed. The option to use either set of rules is based on the rules for basis adjustments. Deaths in 2010 result in only limited basis adjustments. For deaths in 2011 the cost basis is the market value on the date of death. The executor will be allowed to choose the rules that are most advantageous to the estate and its beneficiaries.
The estate tax revisions enacted in December 2010 are temporary and are scheduled to expire after 2012.
So why not give all of your property to your heirs before you die and avoid any estate tax that might apply? Clever, but the government is ahead of you. As noted above, you can move a lot of money out of your estate using the annual gift tax exclusion. Go beyond that, though, and you begin to eat into the exclusion that offsets the bill on the first $1 million of lifetime gifts. Go beyond the $1 million and you'll have to pay the gift tax—at rates that mirror the individual income tax, up to 35% in 2010.
You know that exclusion that protected you from the tax on the first $1 million of gifts in 2010? Every $1 you use to pay the tax on lifetime gifts reduces by $1 the exclusion that otherwise would offset estate taxes on up to $3 million after you die. Bottom line: You can't avoid the estate tax by giving your wealth away. That does NOT mean there are no estate planning advantages to making gifts. There are, and they will be discussed later.
Beginning in 2011, the gift tax and the estate tax will be unified with an exclusion amount of $5 million. The estate tax exclusion had been scheduled to expire in 2010 and then reappear in 2011 with a $1 million exclusion. The new estate tax exclusion is now scheduled to expire after 2012.
The basic tax basis issue
As you consider making gifts, keep in mind that very different rules determine the tax basis of property someone receives by gift versus receives by inheritance. For example, if your son inherits your property, his tax basis would be the fair market value of the property on the date you die. (Special rules apply for deaths that occur in 2010.) That means all appreciation during your lifetime becomes tax-free.
However, if he receives the property as a gift from you, his tax basis is whatever your tax basis was. That means he'll owe tax on appreciation during your life, just like you would have had you sold the asset. The rule that "steps up" basis to date of death value for inherited assets saves heirs billions of dollars every year.
For 2010 only, estates of decedents who died during the year have the option of using the stepped-up basis rule with a $5 million exclusion or using a carryover basis rule with no estate tax. Using the carryover basis rule, when you inherit the property, you also inherit the decedent's basis for that property. Therefore, when you sell the property, you will report a gain if the property has appreciated over the decedent's basis. The tax relief act recently signed into law by President Obama eliminates the carryover basis rules after 2010.
A tax basis example
Your mother has a house with a tax basis of $60,000. The fair market value of the house is now $300,000. If your mother gives you the house as a gift, your tax basis would be $60,000. If you inherited the house after your mother's death in 2009, the tax basis would be $300,000, its fair market value on the date of her death. What difference does this make? If you sell the house for $310,000 shortly after you got it:
- Your gain on the sale is $250,000 ($310,000 minus $60,000) if you got the house as a gift.
- Your gain on the sale is $10,000 ($310,000 minus $300,000) if you got the house as an inheritance.
What is a gift?
For tax purposes, a gift is a transfer of property for less than its full value. In other words, if you aren't paid back, at least not fully, it's a gift.
In 2010, you can give a lifetime total of $1 million in taxable gifts (that exceed the annual tax-free limit) without triggering the gift tax. Beyond the $1 million level, you would actually have to pay the gift tax. For gifts made after 2010, the gift tax exclusion rises to $5 million.
Gifts not subject to the gift tax
Here are some gifts that are not considered "taxable gifts" and, therefore, do not count as part of your $1 million lifetime total.
- Present-interest gift of $13,000 in 2010. "Present-interest" means that the person receiving the gift has an unrestricted right to use or enjoy the gift immediately. In 2010 you could give amounts up to $13,000 to each person, gifting as many different people as you want, without triggering the gift tax.
- Charitable gifts
- Gifts to a spouse who is a U.S. citizen. Gifts to foreign spouses are subject to an annual limit of $134,000 in 2010, indexed for inflation.
- Gifts for educational expenses. To qualify for the unlimited exclusion for qualified education expenses, you must make a direct payment to the educational institution for tuition only. Books, supplies and living expenses do not qualify. If you want to pay for books, supplies and living expenses in addition to the unlimited education exclusion, you can make a 2010 gift of $13,000 to the student under the annual gift exclusion.
Example: In 2010, an uncle who wants to help his nephew attend medical school sends the school $15,000 for a year's tuition. He also sends his nephew $13,000 for books, supplies and other expenses. Neither payment is reportable for gift tax purposes. If the uncle had sent the nephew $28,000 and the nephew had paid the school, the uncle would have made a taxable gift in the amount of $15,000 ($28,000 less the annual exclusion of $13,000) which would have reduced his $1 million lifetime exclusion by $15,000.
The gift tax is only due when the entire $1 million lifetime gift tax amount ($5 million starting in 2011) has been surpassed.
Payments to 529 state tuition plans are gifts, so you can exclude up to the annual $13,000 amount. In fact, you can give up to $65,000 in one year, using up five year's worth of the exclusion, if you agree not to make another gift to the same person in the following four years.
Example: A grandmother contributes $65,000 to a qualified state tuition program for her grandchild in 2010. She decides to have this donation qualify for the annual gift exclusion for the next five years, and thus avoids using a portion of her $1 million gift tax exemption.
- Gifts of medical expenses. Medical payments must be paid directly to the person providing the care in order to qualify for the unlimited exclusion. Qualifying medical expenses include:
- Diagnosis and treatment of disease
- Procedures affecting a structure or function of the body
- Transportation primarily for medical care
- Medical insurance, including long-term care insurance
In addition to these gifts that are not taxable, there are some transactions that are not considered gifts and, therefore, are definitely not taxable gifts.
- Adding a joint tenant to a bank or brokerage account or to a U.S. Savings Bond. This is not considered to be a gift until the new joint tenant withdraws funds. On the other hand, if you purchased a security in the names of the joint owners, rather than holding it in street name by the brokerage firm, the transaction would count as a gift.
- Making a bona fide business transaction. Even if you later find out that you paid more than the item was worth based on its fair market value, the transaction is not a gift; just a bad business decision.
Gifts subject to the gift tax
The following gifts are considered to be taxable gifts when they exceed the annual gift exclusion amount of $13,000 in 2010. Remember, taxable gifts count as part of the $1 million in 2010 you are allowed to give away during your lifetime, before you must pay the gift tax.
- Checks. The gift of a check is effective on the date the donor gives the check to the recipient. The donor must still be alive when the donor's bank pays the check. This rule prevents people from making "deathbed gifts" to avoid estate taxes.
- Adding a joint tenant to real estate. This transaction becomes a taxable gift if the new joint tenant has the right under state law to sever his interest in the joint tenancy and receive half of the property. Note that the recipient only needs to have the right to do so for the transaction to be considered a gift.
- Loaning $10,000 or more at less than the market rate of interest. The value of the gift is based on the difference between the interest rate charged and the applicable federal rate. Applicable federal rates are revised monthly. This rule does not apply to loans of $10,000 or less.
- Canceling indebtedness
- Making a payment owed by someone else. This is a gift to the debtor.
- Making a gift as an individual to a corporation. Such a donation is considered to be a gift to the individual shareholders of the corporation unless there is a valid business reason for the gift. Such a donation is not a present-interest gift, and thus does not qualify for the annual per person per year exclusion.
Example: A son owns a corporation worth $100,000. His father wants to help his son and gives the corporation $1 million in exchange for a 1 percent interest in the company. This is a taxable gift from father to son in the amount of $1 million less the value of one percent of the company.
- A gift of foreign real estate from a U.S. citizen. For example, if a U.S. citizen gives 100 acres he owns in Mexico to someone (whether or not the recipient is a U.S. citizen), it is subject to the gift tax rules if the land is worth more than $13,000.
- Giving real or tangible property located in the United States. This is subject to the gift tax rules, even if the donor and the recipient are not U.S. citizens or residents. Nonresident aliens who give real or tangible property located in the United States are allowed the $13,000 annual present-interest gift exclusion and unlimited marital deduction to U.S. citizen spouses, but are not allowed the $1 million lifetime gift tax exemption.
How gifts to minors are taxed
If you give an amount up to $13,000 to each child each year, your gifts do not count toward the $1 million of gifts you are allowed to give in a lifetime before triggering the gift tax. But what counts as a gift to a minor?
- Gifts made outright to the minor
- Gifts made through a custodial account such as that under the Uniform Gifts to Minors Act (UGMA), the Revised Uniform Gifts to Minors Act, or the Uniform Transfers to Minors Act (UTMA)
Note: One disadvantage of using custodial accounts is that the minor must receive the funds at maturity, as defined by state law (generally age 18 or 21), regardless of your wishes.
A parent's support payments for a minor are not gifts if they are required as part of a legal obligation. They can be considered a gift if the payments are not legally required.
Example: A father pays for the living expenses of his adult daughter who is living in New York City trying to start a new career. These payments are considered a taxable gift if they exceed $13,000 during 2010. However, if his daughter were 17, the support payments would be considered part of his legal obligation to support her and, therefore, would not be considered gifts.
Advantages of making a gift
Giving a gift may earn you more than gratitude:
- Reduced estate taxes. Moving money out of your estate via lifetime gifts can pay off even if those gifts trigger the gift tax. How? By removing future appreciation on the asset from your estate. Say, for example, that you give your daughter real estate worth $1,013,000, using up your $13,000 exclusion and your entire $1,000,000 2010 lifetime gift exclusion. If the property is worth $3,013,000 when you die, that's $2,000,000 less to be taxed in your estate.
- Reduced income taxes. If you give property that has a low tax basis (such as a rental house that has depreciated way below its fair market value), or property that generates a lot of taxable income, you may reduce income taxes paid within a family by shifting these assets to family members in lower tax brackets.
- Teaching your family to manage wealth. Giving family members assets now allows you to monitor their ability to handle their future inheritance.
Disadvantages of making a gift
- Reduces your net worth. You need to keep enough assets to care for yourself throughout a long or extended retirement or illness.
- The Kiddie Tax. Giving funds to children may subject them to the Kiddie Tax, which applies the parents' tax rates to investment earnings of their children that exceed a certain amount. For 2010, the Kiddie Tax applies to investment income exceeding $1,900 for a child under age 19.
How to report and pay the gift tax
If you make a taxable gift, you must file
Form 709: U.S. Gift (and Generation-Skipping Transfer) Tax Return, which is due April 15 of the following year. Even if you do not owe a gift tax because you have not reached the $1 million limit, you are still required to file this form if you made a gift that exceeds the $13,000 annual gift tax exclusion level. The IRS needs to keep a running tab of your lifetime exemption.
Example 1
In 2010, you give your son $14,000 to help him afford the down payment on his first house. This is a gift, not a loan. You must file a gift tax return and report that you used $1,000 ($14,000 minus the $13,000 annual exclusion) of your $1 million lifetime exemption.
Example 2
Same facts as above, except that you give your son $12,000 and your daughter-in-law $2,000 to help with the down payment on a house. Both gifts qualify for the annual exclusion. You do not need to file a gift tax return.
Example 3
Same facts in Example 1, but your spouse agrees to "split" the gift—basically this means he or she agrees to let you use part of his or her exclusion for the year. A husband, for example, could give $26,000 to his son without triggering the gift tax if his wife agrees not to give the son any gift that year. Although no tax is due in this situation, the husband would be required to file a gift tax return indicating that the wife had agreed to split the gift.
Forms, publications and tax returns
On a gift tax return you report the fair market value of the gift on the date of the transfer, your tax basis (as donor) and the identity of the recipient. You should attach supplemental documents that support the valuation of the gift, such as financial statements in the case of a gift of stock in a closely-held corporation or appraisals for real estate.
If you sell property or family heirlooms to your child for full fair market value, you don't have to file a gift tax return. But you may want to file one anyway to cover yourself in case the IRS later claims that the property was undervalued, and that the transaction was really a partial gift. Filing Form 709 begins the three-year statute of limitations for examination of the return. If you do not file a gift tax return, the IRS could question the valuation of the property at any time in the future.
