The federal estate tax was touch and go for a while, applicable in some years but not in others, until the American Taxpayer Relief Act made it permanent, effective Jan. 1, 2013. ATRA also bumped the estate tax rate up from 35 percent to an eye-popping 40 percent at that time.
Fortunately, only a small percentage of estates – only two out of every 1,000 in 2017 – have to deal with this significant tax rate because the federal government offers an exemption. Only the portion of an estate that exceeds this exemption amount is taxed, and the exemption has been in the millions of dollars for many years. As a result, only the wealthiest estates end up being taxed.
But that exemption doesn’t just cover estate taxes. It also applies to the federal gift tax – these two taxes share it. The tax code lumps all giving together under one umbrella regardless of whether you do it during your lifetime or at the time of your death when your property must by necessity pass to living beneficiaries.
The value of your taxable lifetime gifts and the value of your taxable estate are collectively covered by this one exemption, called the Unified Tax Credit.
The Unified Tax Credit combines an exemption for the federal gift tax and the federal estate tax as well.
Your Taxable Estate
Tax laws are full of checks and balances so the taxable value of your estate probably isn’t as much as you think it might be. The Unified Tax Credit only applies to the taxable value – not the overall gross value – of your estate.
First, add up the fair market value of everything you own and everything in which you have an ownership interest. Remember, your ownership interest in an asset is only representative of your particular share. If you own half of a $500,000 building, your ownership interest is valued at $250,000, not the entire amount.
The figure you come up with is your gross estate, not your taxable estate. Next, you can subtract the overall value of any liens that might exist against these assets, such as mortgages. You can also deduct expenses associated with settling your estate. And if your spouse or any qualified charities inherit any of these assets, you can subtract their particular values from the total as well because these gifts aren’t taxable.
You’re left with your taxable estate … and depending on how generous you were with gifts during your lifetime, your estate might not owe an estate tax thanks to the Unified Credit. In fact, depending on the extent of your wealth, it probably won't.
Unified Tax Credit in 2018
The Unified Credit is pretty generous in 2018 – a whopping $11.18 million, up from $5.49 million in 2017 thanks to the terms of the Tax Cuts and Jobs Act. But remember, this credit covers both taxable gifts you've made and the value of your estate. The taxable value of gifts you’ve given must be subtracted from the credit and the balance is what can be applied to your estate.
For example, you'd have a $10 million Unified Credit left if you gifted $1.18 million over the course of your lifetime. So if your taxable estate – not your gross estate – is less than $10 million, all is well. No tax is due because the Unified Tax Credit has you covered. But if your taxable estate is valued at $11 million, that extra $1 million is taxed at the rate of 40 percent. Your estate would owe $400,000 in estate taxes.
On the bright side, that’s still a lot less than you would have paid if you hadn’t been able to subtract the Unified Credit dollar for dollar from the value of your estate. And if you’re married, both you and your spouse are entitled to your own Unified Credit. That translates to $22.36 million per couple in 2018.
And you’re always free to preserve your credit. No law says that you must charge your taxable gifts against the Unified Credit amount. You can always go ahead and pay the gift tax in the year you make taxable gifts.
Annual Exclusion Vs. Lifetime Exemptions
The term “taxable gifts” is just as integral to this equation as your taxable – not gross – estate. It’s not the total value of everything you’ve ever given away because the federal tax code also offers an annual gift tax exclusion in addition to the Unified Credit.
You can give this much away per person per year without your generosity counting as a taxable gift. The Internal Revenue Service never has to learn about your giving and the amount doesn’t deduct from your Unified Credit. You don’t have to file a gift tax return.
This annual exclusion is $15,000 as of 2018. You can give 10 different individuals $15,000 each for a total of $150,000 – and you could do that year after year – and these wouldn’t be taxable gifts or affect your Unified Credit in any way. You don’t have to subtract this amount to calculate how much of your Unified Credit is left to protect your estate.
And this tax gift is also per donor so if you’re married, you and your spouse can each give $15,000 a year to the same person for a total of $30,000.
Some Gifts Don’t Count
Not all gifts are taxable no matter how much they’re worth. They don’t count against the annual exclusion amount or the Unified Credit amount.
You can give money or property to certain qualified charities all day long, week in and week out, without ever paying a gift tax on the value – or an estate tax, either, for that matter. You can also pay someone’s education or medical bills for them tax-free as long as you give the money directly to the learning institution or the care provider and not to the beneficiary of your generosity.
Lifetime gifts and bequests to your spouse don’t count, nor do gifts made to political organizations. If you were particularly generous before 1977, these aren’t taxable gifts, either. They don’t count against your Unified Credit no matter how much they were worth.
But otherwise, anything you give per person per year over $15,000 counts against your credit … unless you go ahead and pay the gift tax in that year.
Using the Unified Tax Credit in 2018
If you do want to use some of your Unified Credit to avoid paying the gift tax, you must file a gift tax return, IRS Form 709, to let the IRS know about it. The IRS is more than glad to keep track of your lifetime gifts for you as you file these returns over the years.
Your estate must file an estate tax return – Form 706 – at the time of your death to claim the Unified Credit, either all of it if you’ve been paying gift taxes over the years or what’s left of it after the taxable value of your gifts is deducted based on your gift tax returns. All taxable estates valued at more than $11.18 million as of 2018 must file an estate tax return regardless, but the executor of your estate will have to file one even if your estate is worth less than this if you’re using your Unified Credit to cover those gifts you made during your lifetime.
The Unified Credit Is “Portable”
So what happens if your entire estate and your lifetime gifts amount to less than the Unified Credit amount? What if your estate is worth just $1 million? Does that remaining $10.18 million Unified Credit just go poof! and disappear?
It doesn’t. You can give it to your surviving spouse if you’re married, effectively transferring it to him. The tax code calls this provision “portability.” Now your spouse has a $21.36 million Unified Credit – his own $11.18 million plus your remaining $10.18 million, the amount you didn’t use assuming you didn’t charge any lifetime gifts against it.
This provision was written into the tax code on the presumption that a surviving spouse is likely to inherit most, if not all, of a decedent’s estate. She should therefore have the corresponding credit, too, when she passes the largess on to her own beneficiaries.
Electing portability also requires the filing of an estate tax return even if no tax is owed.
Warning – The Clock Is Ticking
The Unified Credit isn’t always the same from year to year, nor is the annual gift tax exclusion. They’re both indexed to increase along with inflation. This means that you can pretty much count on the annual gift tax exclusion going up periodically in $1,000 increments, although this might not happen every year if the economy remains relatively steady.
As for the $11.18 million Unified Credit, this might actually decrease in future years even as inflation adjustments are made to it. These inflation adjustments would most likely not be more than the difference between the 2017 Unified Credit – $5.49 million – and the current $11.18 million amount ... and it's possible that the Unified Credit might revert back to $5.49 million at some point in the future.
Remember that this big jump in the Unified Credit came about because of the Tax Cuts and Jobs Act, which was signed into law in December 2017. But the TCJA isn’t forever. Many of its provisions sunset or expire after 2025 unless Congress acts to renew the tax law, including the estate tax exemption and the Unified Credit.
It’s entirely possible that the Unified Credit could drop back to somewhere in the neighborhood of $5.49 million in 2026, right where it was in 2017 plus any inflation adjustments for the years in between. Holding onto your extra money or property until after that time might be a little like rolling dice. Depending on the anticipated value of your estate, you might want to talk to a tax advisor or an estate planning attorney to determine whether it’s better for you to give now or wait until later.
“Anticipated value” can be the key words here. If your estate is comprised of assets that are likely to appreciate in value over time, this is something you might want to keep in mind as the sunset of the TCJA potentially looms on the horizon. This makes expert advice pretty much a must-have as you’re planning your estate.
Of course, the current $11.18 million Unified Credit can be expected to creep upward each year between now and 2026 as well – those inflation adjustments again. It’s conceivable that its value could reach an all-time peak in 2025.
- CPA Practice Advisor: Estate Planning and the New 2018 Tax Law
- What's New - Estate and Gift Tax | Internal Revenue Service
- IRS: Estate Tax
- Bankrate: Estate and Gift Tax Exemption Amounts for 2016-2017
- Charles Schwab: The Estate Tax and Lifetime Gifting
- Center on Budget and Policy Priorities: Ten Facts You Should Know About the Federal Estate Tax