I was in line at the grocery store this past week and I overheard the family behind me talking with their teenage son about gifting him a car.
The father mentioned that he was pretty sure there was a limit to how much can be gifted to a person before it became taxable.
I politely introduced myself and asked if he is referring to the annual gift exemption of $15,000. “Yes, that’s it!” he proclaimed.
As you can imagine, they had a few more questions about how these gifts work so we spoke for another 10 minutes about it.
This topic is often misunderstood so I thought I’d take the opportunity to cover it this week and hopefully break it down so that it’s easy to understand.
what is the gift tax?
The IRS lumps together all gifts you make during your lifetime with gifts you make as bequests from your estate when you die and assesses a 40% tax that a gift-giver must pay to the Federal government on those gifts.
In the IRS’s eyes, the federal gift tax applies to any gift you make during your lifetime – all the way from the $1 you gave to your niece to something as large as paying off someone’s student debt.
You are technically supposed to track every single gift you make, no matter the size. But the IRS knows that is impractical so they have two options for avoiding the gift tax.
The first is an annual exclusion and the second is a lifetime exemption.
The Annual Gift Tax Exclusion
The annual exclusion allows you to make gifts up to $15,000 per year per person (as of 2020) without being impacted by the gift tax.
You read that right. You can give $15,000 to an unlimited number of individuals in a year without even thinking about the gift tax.
It gets even better if you are married. You and your spouse are each entitled to a $15,000 exclusion and can give up to $30,000 per person.
These gifts don’t count against your lifetime exemption. It will only kick in when you exceed this annual amount in a given year.
The Lifetime Exemption
Only the gifts above the $15,000 annual exclusion begin to impact your lifetime exemption of $11.58 million (as of 2020). And it’s not until you go over the lifetime exemption that you are required to pay the 40% tax on the gifts.
Keep in mind that you do need to report gifts over the annual exclusion to the IRS on Form 709. This records how much you’ve gone over the annual exclusion each year (the amounts that count against your lifetime exemption).
Of course, you are free to pay the taxes on the gifts when you file the tax return. You are not required to let them count against your lifetime exemption.
Eventually, at the end of your life when your estate settles, all these annual overages are added up and applied to your lifetime exemption. It’s only when your excess gifts plus the value of your estate exceed the lifetime exemption of $11.58 million that you’ll be taxed.
A Gift Tax Example
If a father makes a gift of a $30,000 car to his son, $15,000 of that gift is free and clear of the federal gift tax, thanks to the annual exclusion. The remaining $15,000 is a taxable gift and would be applied to his lifetime exemption if he chose not to pay the tax in the year he made the gift.
Remember though, the mother could also gift part of that car, and in this case, none of it would impact their lifetime exemptions.
But what if that car was worth $80,000? The father and mother could both use their annual exclusion of $15,000 ($30,000 total) but the remaining $50,000 would need to be reported on Form 709. There would technically be two Form 709’s – one for each of them – as each individual is responsible for their own 709.
This is a relatively straightforward and oversimplified example. Things can get really complicated when you begin to consider gifts of community property. A topic for another article for sure!
What does the irs consider a gift?
The Internal Revenue Service considers a gift to be virtually any transfer of cash or property in which the giver doesn’t receive something of equal value in return.
If you give someone cash with the understanding that they won’t pay you back, that’s a gift. If you sell someone a $300,000 home for $150,000, you’ve made a gift of $150,000.
This is all based on the IRS definition of “fair market value.” Cash is what it is, so there’s rarely any doubt there. As for that house, the IRS says its fair market value is what someone could be expected to pay for it if neither the buyer nor the seller was under any sort of duress to commit to the transaction.
tax-exempt Gifts
There are a few types of gifts that are inherently tax-free, regardless of the lifetime exemption. These include:
- Gifts to IRS-approved charities
- Gifts to your spouse (assuming he or she is a U.S. citizen)
- Gifts covering another person’s medical expenses, as long as you make the payments directly to medical service providers
- Gifts covering another person’s tuition expenses, as long as you make payments directly to the educational institution. (Payments for room and board, books, and supplies don’t qualify for this exception, but you can cover those costs by making a direct gift to the student under the annual exclusion.)
Remember state estate taxes
Even if your estate isn’t big enough to owe federal estate tax, your state may still have an estate tax.
For example, in Oregon, estates worth more than $1 million may owe state estate tax. Property left to a surviving spouse, however, is exempt from state estate tax, just as it is exempt from federal estate tax.
More information on each state’s estate tax.
A few states also impose a separate tax, called an inheritance tax, on a deceased person’s property. The rate depends on who inherits the property; usually, property that passes to spouses and other close relatives is not taxed or is taxed at a very low rate.