The Internal Revenue Service defines unearned income as investment-type income that doesn't qualify as earned income. In contrast, gifts aren't considered to be income at all by the IRS. Recipients never owe taxes on gifts, but they do owe taxes on unearned income. The tax they pay on unearned income depends on the type of unearned income it is.
The IRS considers a gift to be a direct or indirect transfer in which the giver doesn't expect an equal amount of consideration in return. In other words, if someone gives you money or another asset and isn't asking for goods or services in exchange, it's a gift. A gift isn't considered income to the recipient, and the purpose of the money isn't relevant in determining whether or not a payment is a gift. Common examples of gifts are someone paying for your medical bills, covering your tuition, buying you a car or writing a check to help you with living expenses.
Tax Consequences of Gifts
It's the giver, not the recipient, who is responsible for any taxes on gifts. However, most individuals won't have to pay a gift tax on what they give. That's because the IRS gives individuals a $5.34 million lifetime exclusion to give tax-free on top of a $14,000 annual exclusion per recipient, as of publication. Some gifts, like paying medical expenses and tuition, are always tax-free. If an individual does determine that he owes tax on the gift, he should fill out Form 709, the Gift Tax Return.
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The IRS broadly defines unearned income as " investment-type income" or "income other than earned income." Earned income is items like wages, salaries, proceeds from business operations and independent contractor income. The most common types of unearned income are interest, dividends, royalties and capital gains. If you receive any of this type of investment income from a trust, it is also considered unearned income.
Tax Consequences of Unearned Income
Not all types of unearned income are taxed the same. Interest income and short-term capital gains are taxed at your normal tax rate. For example, if you're in the 25 percent tax bracket, any additional interest income and short-term capital gains is taxed at that rate. Long-term capital gains and dividends have separate tax rates that are generally lower than normal tax rates. You have a long-term capital gain if you owned the asset for more than a year before you sold it. Otherwise, it's a short-term gain.
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