When Are Gifts Taxed?
I first became aware of a gift tax when I was playing my first game of Monopoly. I landed on the Community Chest space, and the card told me to pay a “gift tax” of $100. I thought to myself, “What the heck is a gift tax?” I know that when I buy a gift, I must pay a sales tax, but why must I pay another tax when I give a gift?
The answer boils down to the federal government’s policy of limiting the ability of rich people to transfer their wealth to their descendants. Theoretically, the taxes collected by the IRS would take from the rich and give to the poor (through government expenditures). If the transfer occurs during a person’s lifetime, the IRS assessment is called a “gift tax”, and if the assets transfer on death, it is called an “estate tax”.
Who are the rich people targeted here? The government has always had a threshold, whereby amounts transferred below the threshold are not taxed. This tax-free transfer amount combines the lifetime gifts and estate value on death into a single unified credit. Current law (2018) established a unified credit where everyone has a lifetime exclusion of $11.18 million for assets transferred. This amount is in effect until at least 2025. Amounts above $11.18 million will be taxed at 40%. In practice, what this means is the vast majority of us will not pay any gift or estate taxes.
But wait! Isn’t there something called an “annual exclusion”? Yes, this is an additional exclusion whereby every year a person can currently (2018) gift $15,000 to as many individuals as he/she likes, which will not be included in the lifetime exclusion amount. You have probably been on the giving or receiving end of this practice, particularly in years past when the lifetime exclusion was much smaller. There was a 10-year stretch from 1987-1997 when the lifetime exclusion was only $600,000. Older people were gifting like crazy to reduce their potential estate tax.
Nowadays, the main reason people use the annual exclusion is to avoid filing an additional form (IRS Form 709) with their federal tax return. If you gift above the annual exclusion, you must fill in and file this form so that the IRS can keep a ledger of your taxable gifts so that after you die, your final estate tax return will determine if you have exceeded the lifetime exclusion.
There are four specific types of donees that will not trigger a gift tax at all: (1) spouses, (2) political organizations, (3) educational institutions for tuition, and (4) medical care providers. There is also a provision whereby the donor can exclude a contribution of up to $75,000 into a 529 plan in a single year for a single beneficiary, which treats it as if $15,000 was gifted in each of the following 5 years. However, any additional gifts to that beneficiary during that 5-year period would require a Form 709 to be filed. There are several other nuances with 529 plans that will be covered in a subsequent article devoted just to 529 plans.
Here are three common, simple illustrations of gifting:
Gift: Tom Jones gives each of his 10 grandchildren $15,000 in 2018 for a total gift of $150,000. Result: No forms to file, no deduction from Tom’s $11.18 million lifetime exclusion.
Gift: Susan Baker pays her grandson’s $60,000 college tuition directly to Harvard. Result: No forms to file, no deduction from Susan’s lifetime exclusion.
Gift: Mary Smith gives her granddaughter a $25,000 car. Result: Since Mary gave a gift to a single individual worth $10,000 above the annual exclusion, Mary files form 709, and $10,000 will be deducted from her $11.18 million lifetime exclusion.
Bottom Line: Any gifts you make during your life will not incur a gift tax during your lifetime. After you die, if the value of your estate (including non-excluded gifts) is less than the lifetime exclusion ($11.18 million in 2018-2025), your heirs will pay no estate tax. However, if you want to give a gift and not hassle with filing an additional tax form to keep track of your lifetime exclusion, keep your gift at or below the annual exclusion limit ($15,000 for 2018). If you think your estate will exceed the exclusion amount, consult your estate attorney to review estate planning strategies.