The federal gift tax is a somewhat tricky tax concept. You might expect that an individual who receives a gift would have to pay a tax on its value, but that’s not the case. The donor is typically responsible for paying the gift tax.
Yes, it’s sort of a double hit. You’re out the property or the money you gifted and you might find that you owe the Internal Revenue Service a little extra besides. The recipient can agree to pay the tax instead but this is subject to IRS approval, and an exception applies if the gift comes from a foreign source – then the recipient must report the gift by filing a gift tax return and paying any associated taxes due.
There are no special rules in the tax code for your offspring. A gift made to your son or daughter is treated just the same as a gift made to your neighbor.
The IRS Definition of “Gift”
So what does the IRS consider to be a gift? The tax code defines it as pretty much anything for which you don’t receive “full consideration” in return. In other words, if your home is worth $300,000 and you transfer ownership to your child in exchange for $250,000, you’ve just given him a $50,000 gift. That's unless you can convince the IRS that you’re actually paying him that $50,000 in exchange for mowing your lawn every weekend for the last 20 years.
Even then, you might be out of luck if most landscapers in your area don’t charge that much. You might only be able to escape taxation on an amount commensurate with what workers in your locale typically charged in the year in question.
As for setting the home’s value, the IRS says it’s fair market value. In tax terms, this is defined as what one individual could be expected to pay to another for the property if neither of them were under any duress to complete the sale. It also assumes that both the buyer and the seller had full knowledge of all details regarding the property at the time the transaction was made.
Gifting to a Child Tax-Free
Gifts are only taxable over a certain threshold known as the annual gift tax exclusion. That exclusion is $15,000 in 2020, up from $14,000 where it was stuck for five years through 2017. So if you want to give your daughter $16,000 to pay off her credit card debt, you’re actually only giving her a $1,000 gift, at least in the eyes of the IRS.
And there are some convenient loopholes here. The annual gift tax exclusion is per person and per year. This means you can give your daughter $15,000 on Dec. 31 and $1,000 on Jan. 1 without incurring a gift tax – both gifts are within the annual gift tax exclusion and they occurred in separate years. Or you might give $15,000 to her and the other $1,000 to her spouse. This wouldn’t incur a gift tax either because the money is going to two separate individuals.
The donor is also taxed per person. This means that you and your spouse can “split” your gifts, each of you making separate gifts to your daughter up to the annual gift tax exclusion amount if you’re married, because you're two separate people. You can give her $15,000 and stay under the exclusion threshold and your spouse can give her the other $1,000. For that matter, you can each give her $15,000 free of the gift tax in 2020 without incurring a gift tax.
Read More: Tax Implications of Giving Your House to Your Child
Reporting Gifts to the IRS
You probably still won’t have to pay the tax if you exceed the annual gift tax exclusion, but you will have to file a gift tax return, Form 709, for the year in which you go over. And you and your spouse will have to file separate Forms 709 if you’ve split your gifts even if you file a joint married tax return for your regular income, regardless of whether one or both of you has exceeded the threshold.
You might also want to back up the value of your gift. If it’s cash, include copies of your bank statement. If you gave property, you might want to include an appraisal or other documentation to show how you determined how much it was worth – its fair market value.
To Pay or Not to Pay
Now you have a choice to make if you’ve exceeded the annual gift tax exclusion. You can either pay up now, remitting the gift tax to the IRS, or you can let the IRS chalk up the difference to your lifetime exemption.
The lifetime exemption is a pretty significant $11.58 million as of 2020, up from $11.18 million as of 2018 and just $5.49 million in 2017 thanks to the Tax Cuts and Jobs Act that was signed into law in December 2017. If you don’t remit payment with your gift tax return, that extra $1,000 in our example will be deducted from your lifetime exemption.
This will happen every year you exceed the annual exclusion amount per person, but at $11.58 million, that’s a whole lot of gifts. Unfortunately, there’s a catch. That same $11.58 million is intended to provide your estate with an estate tax exemption when you die.
Gifts and Estate Tax Exemption
As an example, maybe you whittle away at your lifetime exemption by making significant lavish gifts each year that exceed the annual gift tax exclusion. The total of all those years of generosity works out to $5 million, and this is subtracted from your lifetime exemption. Now there’s only $6.58 million remaining of your $11.58 million lifetime exemption – that's all you have left to shelter your estate from estate taxes when you die.
If your estate turns out to be worth $10 million, it will be charged a 40 percent estate tax on the $3.42 difference between the remaining lifetime exemption ($6.58 million) and the taxable value of your estate ($10 million).
All those Forms 709 that you must submit each year you go over the annual gift tax exclusion allow the IRS to keep track of all this giving. You do not have to file a gift tax return if you don’t exceed the annual gift tax exclusion, however.
Now here’s a bit of good news. Not all gifts are treated equally. Some are actually exempt from the gift tax even if they exceed the annual exclusion amount.
These include medical or educational expenses you pay on someone else’s behalf, provided that you pay the care provider or the learning institution directly. If you pay off your son’s medical bills to the tune of $30,000, that gift is completely tax-free. The same applies if you give your daughter $20,000 to cover her tuition and you give the money to the school. The money just can’t pass through their hands first.
And if you’re married, you can give to your spouse to your heart’s content. No tax will come due no matter how much you give her. There’s a catch here, too, however: She must be a U.S. citizen. Otherwise, only the first $157,000 per year is tax-free as of 2020.
You can also give gifts to political organizations and to qualified charitable organizations free of charge.
Are Gifts Tax Write-Offs?
As a general rule, you can’t take a tax deduction or write-off for most gifts you give, but there are some exceptions.
You’ll pay income tax on the value of any cash or property you give to anyone at the time you earn the income, except when you give to a qualified charity. This is an itemized tax deduction on your income tax return as of 2020, and you can also subtract the fair market value of these gifts from your gift tax return as well.
As for that tuition you want to pay on behalf of your daughter, you can get a tax break for that gift as well if you use the money to fund a 529 plan naming her as the beneficiary rather than give the money directly to the school. The money would still be subject to a gift tax if it exceeds the annual exclusion because you’re not paying the learning institution, but a special tax rule allows you to spread it out over five years’ worth of annual exclusions, which can help prevent any gift tax from coming due.
Tips to Manage Your Generosity
As with anything tax-related, doing it right counts. Remember that $11.58 million lifetime exemption? Technically, it could revert back into the $5 million range after the Tax Cuts and Jobs Act expires. It’s set to sunset at the end of 2025. If you wait too long to start giving or if you die in 2026 or later, there’s no guarantee that the federal government will be quite so generous at that time.
And here’s another consideration if you’re gifting property or assets such as investment accounts, stocks or bonds. They might be worth $15,000 now but they’ll most likely grow to a value well in excess of that by the time of your death – when you’ll want to use that lifetime exemption to avoid estate taxes on your estate instead.
In other words, you can give $15,000 now without incurring a gift tax, but if you hold onto the property and it’s worth twice as much at the time of your death, your lifetime exemption must now cover $30,000. Meanwhile, giving now in that amount is covered by the annual gift tax exclusion so it won’t subtract from your lifetime exemption at all.
Watch the Timing Wrinkle
And here’s another wrinkle. Estate taxes have to be paid before your beneficiaries receive anything from your estate. So if you postpone the gift and the lifetime exemption drops again by the time of your death, you could actually be taking from your beneficiaries, not giving to them. You might want to allow that growth to happen under their ownership, not yours, but you’ll want to consult with a tax professional before you decide one way or another.
Keep in mind, too, that these rules, exclusions and exemptions apply at the federal level. Some states have estate and gift taxes of their own and the rules could be entirely different. In most cases, exemption amounts at the state level are much less. That’s another good reason to check with a tax professional before you pull out your checkbook.
Beverly Bird has been writing professionally for over 30 years. She is also a paralegal, specializing in areas of personal finance, bankruptcy and estate law. She writes as the tax expert for The Balance.