The gift tax is a tax levied on any unilateral transfer (a gift) from one person to another. The federal tax is aimed partially at making sure wealthy families don’t use gifts to bypass the estate tax.
The federal gift tax applies to any kind of taxable assets, including cash, securities and real estate. When the gift tax applies, it is the donor who pays, meaning that if you give a taxable gift you owe any applicable taxes. If you receive a gift, it is rare, if ever, that you owe taxes. It is exceedingly rare for someone to owe money due to the gift tax. This tends to apply only to the wealthiest of households due to the tax’s high exclusions. This is because the purpose of the gift tax is to prevent wealthy families from avoiding the estate tax by simply gifting all their money to each new set of heirs. Here’s what you need to know.
Consider working with a financial advisor as you seek ways to transfer wealth to family members or loved ones.
What Is the Gift Tax?
Per the IRS, this is a tax levied on “[a]ny transfer to an individual, either directly or indirectly, where full consideration (measured in money or money’s worth) is not received in return.” If you give something of value and get less than it is worth in return, it is considered a gift and may be taxable under this law.
Importantly, this applies if you give something of value and get a nominal amount in return. (In law this is called a “de minimis” transaction.) For example, say you want to give your children the family house. Instead of giving it outright you sell it to them for $100. You do this because ordinarily a property sale doesn’t trigger the gift tax. From a legal standpoint the parties have exchanged assets so the only relevant tax would be on any capital gains.
However, in this case the sale price had no bearing on the fair market value of the property (otherwise known as “full consideration”). As a result you would owe taxes on the difference between the house’s sale price ($100) and its fair market value. Structuring this sale specifically to avoid the gift tax would be a form of felony tax fraud.
This is a particularly common type of tax evasion among family businesses and within closely held real estate companies.
Should you owe gift taxes, the applicable tax rates range from 18% to 40%, depending on the amount of the taxable gift. This tax is progressive, meaning that each bracket only applies to its segment of value. For example, no matter how much you give as a gift, you only pay 18% on the first $10,000.
Gift Tax Exclusions
As noted in our introduction, the person who gives the gift owes any relevant taxes. However, you don’t owe taxes on any gift that falls within an applicable exclusion. The gift tax comes with two forms of exclusions, the annual exclusion and the lifetime exclusion. The annual exclusion is the amount of money or value that you can give each year without affecting your gift tax status overall; the lifetime exclusion is the amount of money or value that you can give over a lifetime after applying the annual exclusion before you begin to owe gift taxes.
The IRS allows you to give an amount of money or equivalent value over the course of your lifetime tax-free. This is called the “lifetime exclusion,” and it’s the amount that you can give before you have to start paying gift taxes.
Each year, when you give a gift, you first apply the annual exclusions then apply any overages to your lifetime exclusion. Then if you have exceeded both that year’s annual exclusion and your overall lifetime exclusion, you would owe taxes on any overages.
Annual exclusions apply per donee, meaning that the annual exclusion is the amount of money you can give to any individual each year before affecting either your lifetime exclusion or your taxes. The lifetime exclusion applies per-donor, meaning that this is the amount of money in total that you can give tax-free over your lifetime. In 2022 the annual exclusion is $16,000, (https://smartasset.com/retirement/gift-tax-limits) while the lifetime exclusion is $12.06 million. This applies per individual, so for a married couple filing jointly these numbers are $32,000 and $24.12 million, respectively.
So, for example, say that in 2022 you gave each of your three children $20,000. With an annual exclusion of $16,000, this would have the following tax consequences:
- Annual Exclusion – You first apply the entire annual exclusion of $16,000 per-person. Since this is per donee, it applies to each of your gifts, so your gifts exceeds the annual exclusion by $4,000 per child.
- Lifetime Exclusion – Your three gifts exceed the annual exclusion by a combined $12,000 (at $4,000 per child times three children). You deduct all three of those from your lifetime exclusion, which is per donor, reducing your lifetime exclusion to $12,048,000 (the starting exclusion of $12,060,000 less the $12,000 overage).
- Taxes Owed – You would owe no taxes on this gift, since you have not yet exceeded your lifetime exclusion.
If your gift(s) exceed the annual exclusion and you have used up your lifetime exclusion, you will owe taxes on the difference. (https://smartasset.com/taxes/understanding-taxes) As its name suggests, the lifetime exclusion applies over the course of your lifetime. This means that if, over a span of decades, you gradually use up this exclusion, you may eventually start to owe taxes on your various gifts.
For example, say that you give each of your three children $5,016,000 in 2022. You would owe taxes on:
- $5,016,000 – $16,000 (annual exclusion) = $5 million per child
- $5 million x 3 children = $15 million in total gifts above the annual limit
- $12.06 million (your lifetime exclusion) – $15 million = -2.94 million
- You would owe taxes on the $2.94 million difference between your gift and the total allowed exclusions
The gift tax does not apply between spouses, nor does it apply to anyone who you claim as a dependent on your taxes. This combination of rules explains why few households ever see gift tax liability. In order to trigger the gift tax, you would need to give someone more $12 million over the course of your lifetime. Moreover, you would generally need to do that in one lump sum since Congress and the IRS periodically raise the limits for both annual and lifetime exclusions. If you have exceeded your lifetime exclusion, but Congress raises the limit above what you have already given, you can continue to give tax-free within the new limits. (https://smartasset.com/retirement/gift-tax-limits)
The best way to avoid paying the gift tax is to structure your gifts over time.
If you are giving someone liquid assets, like cash or investment securities, doing so on an annual basis is a good way to avoid triggering gift tax liability. The annual exclusion refreshes, so you can give up to that amount every year without any tax consequences.
Where this often becomes a problem is when it comes to transferring large, unified assets like a piece of real estate or a family business. You can’t break a house up into parcels of $15,000, so this generally will need to be a lump sum transaction. If the value of the property exceeds the lifetime exclusion, you may not be able to avoid paying taxes on some of it.
Nevertheless some households will break up ownership of large assets in order to avoid this situation. For example, say that you give your two children each joint ownership of the family house. From the IRS’s perspective, each would receive a gift from you worth 50% of the property’s value. This would allow you to jointly give them a home worth $24.12 million with no taxes. If you are a married couple, you could jointly give your two children a home worth $48.24 million with no tax consequences.
- Chained Gifts – Sometimes a donor will try to use what is called a chained gift to exceed their lifetime exclusion. Say that Steve wants to give a home worth $20 million to his daughter Rebecca. He gives it jointly to Rebecca and his friend Robert. The IRS values this gift as $10 million to each party (half the property’s value per person) which stays under Steve’s lifetime exclusions. Robert, who can also give Rebecca up to $12.06 million tax free, then deeds his interest in the property to Rebecca. Theoretically, Rebecca has now received the house free and clear with no tax consequences. In addition to requiring extraordinary levels of trust, this may or may not be legal depending on the specific circumstances. Do not attempt it without consulting a tax attorney first.
There are few, if any, exemptions or deductions to the gift tax. The best way to avoid paying this tax is to structure your gifts to stay within annual and lifetime limits.
Two specific circumstances require additional note:
- Tuition and medical bills – These are generally exempted from the gift tax regardless of the recipient.
- Securities – If you give someone securities or other investments, the cost basis for the asset is its value at the time of the transfer, not at the time when the person giving the securities bought them.
The Bottom Line
The gift tax is a tax that the IRS levies on unilateral (that is, uncompensated) transfers. It is intended to prevent wealthy families from passing down their money free of the estate tax, and as a result only applies once you have given more than $12 million in assets to any given individual.
Tips on Taxes
- Structuring your finances can make an absolute world of difference, but it isn’t always easy. The best way to approach this complicated issue is with smart, sound planning. That’s where financial advisors can be so valuable. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Income in America is taxed by the federal government, most state governments and many local governments. The federal income tax system is progressive, so the rate of taxation increases as income increases. Use our free calculator to estimate your federal income taxes.
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