a. How the Federal Gift and Estate Tax Work Together
The federal gift tax is part of what’s called the “unified” federal gift and estate tax. Gift tax applies to lifetime gifts; estate tax applies to assets left at death. The idea is that whether you give assets away while you’re alive, or leave them at your death, they’re taxed the same way, at the same rate. After all, if there were no gift tax, then anyone could completely avoid the estate tax by giving everything away just before death.
Very few Americans need to worry about federal estate tax or the federal gift tax. Why? Because under current law, each of us has a lifetime gift and estate tax exemption of $ 5.25 million, which means that you can leave or give away up to $ 5.25 million without owing any federal tax. For deaths in 2014, the individual exemption is $ 5.34 million. So, for example, if during your life you give your children your house, worth $ 1 million, plus another $ 4 million in stocks and bonds, no federal gift tax will be due.
If you think that your estate might owe estate tax, one way to avoid or reduce the tax bill is to give away property during your life. In 2013 or 2014, you can make an unlimited number of $ 14,000 gifts of cash or other property, completely tax-free. To ensure these tax savings, you need to remember that no individual recipient can receive more than $ 14,000 in a calendar year.
b. Gift Tax Basics
If a gift is taxable, the person who makes the gift must pay the tax. Even though you must file a gift tax return if you make a taxable gift, you can choose to either pay the tax or use some of your unified gift and estate tax exemption to defer (and probably avoid) paying it. Usually, tax isn’t paid until someone makes so many taxable gifts that the $ 5.25 million exemption is exceeded. Needless to say, very few people, if any, give away that much money during their lives.
At someone’s death, federal estate tax is calculated. In addition to the property left behind (the estate), the amount of taxable lifetime gifts is included in the total that may be subject to estate tax. Again, no tax is due unless the taxable estate exceeds the exempt amount.
i. What’s a gift?
A gift is any transfer for which the maker receives nothing, or less than “fair market value,” in exchange. For example, if you hand someone $ 5,000 in cash, that’s a gift. And if the fair market value of your house is $ 300,000 on the open market but you sell it to your daughter for $ 100,000, you’ve made a $ 200,000 gift to her.
ii. Are there any gifts that aren’t taxable?
Generally, the following gifts are not taxable:
• Gifts that are not more than the annual exclusion for the calendar year
• Tuition or medical expenses paid directly to an educational or medical institution for someone else,
• Gifts to your spouse (if your spouse is a U.S. citizen),
• Gifts to a political organization for its use, and
• Gifts to charities.
iii. What’s the gift tax rate?
The current federal gift/estate tax rate is 40%.
c. How the Annual Exclusion Works
The $ 14,000 annual tax exemption rule is pretty straightforward. For instance, if you give $ 20,000 to someone, $ 14,000 of it is exempt from gift tax, but you must pay gift tax on the remaining $ 6,000.
The following example illustrates how the annual exclusion works. In 2013, John makes a one-time gift of $ 114,000 to his son for the purchase of a home. $ 14,000 of the gift is free and clear of the federal gift tax due to the annual exclusion. The remaining $ 100,000 is a taxable gift made by John to his son. But instead of paying a gift tax, John will simply reduce his lifetime gift tax exemption by $ 100,000. Thus, in 2014, John will be able to give away another $ 5,240,000 before any federal gift tax will be due:
$ 5,340,000 lifetime gift tax exemption in 2014 (-) $ 100,000 taxable gift = $ 5,240,000 lifetime gift tax exemption remaining
Once the entire $ 5,340,000 lifetime gift tax exemption is used up, a federal gift tax will be owed.
d. Gift Splitting
If you or your spouse makes a gift to a third party, the gift can be considered as made on-half by your and one-half by your spouse. This is known as gift splitting. Both of you must agree to split the gift. If you do, you each can take the annual exclusion for your part of the gift.
Currently, gift splitting allows married couples to give away $ 28,000 worth of property tax-free, per year, per recipient. If you split a gift you made, you must file a gift tax return to show that you and your spouse agree to use gift splitting. You must then file a Form 709 even if half of the split gift is less than the annual exclusion.
The following is an example. Harold and his wife, Helen, agree to split the gifts that they made during 2011. Harold gives his nephew, George, $ 21,000. And Helen gives her niece, Gina, $ 18,000. Although each gift is more than the annual exclusion ($ 13,000 in 2011), by gift splitting they can make these gifts without making a taxable gift.
Harold’s gift to George is treated as one-half ($ 10,500) from Harold and one-half ($ 10,500) from Helen. And Helen’s gift to Gina is also treated as one-half ($ 9,000) from Helen and one-half ($ 9,000) from Harold. In each case, because one-half of the split gift is not more than the annual exclusion, it is not a taxable gift. However, each of them must file a gift tax return.
e. Steps in Determining Gift Tax Liability
i. Step 1: Calculate the FMV of your gift. This is the price that a normal buyer and seller would agree upon.
ii. Step 2: Subtract your $ 14,000 annual deduction from the value of your gift. If the gift was larger than the $ 13,000 deduction, you need to file a gift tax return.
iii. Step 3: Review how much you have remaining in your lifetime gift tax exemption. As of 2013, you have a $ 5,250,000 lifetime gift tax exemption. This is the amount that you can give away tax-free on top of the annual deduction. For example, if last year you made a gift of $ 1,014,000, the annual deduction takes off $ 14,000 and the other $ 1 million is taken off your lifetime exemption. You have $ 4,250,000 remaining in your lifetime exemption.
iv. Step 4: Subtract the value of your gift (after taking into account the annual deduction) from your remaining lifetime exemption. If your remaining exemption is larger than the gift, you won’t owe any taxes. If the gift is larger than your remaining lifetime exemption, you will owe gift taxes.
v. Step 5: Multiply the remaining value of your gift by the gift tax rate for the applicable year.
vi. Step 6: Report your gift on IRS Form 709 and pay your owed gift taxes.
f. Applying the Unified Credit for Gift Tax
After you determine which of your gifts are taxable, you must figure out the amount of gift tax on the total taxable gifts and apply your unified credit for the year.
The following is an example. In 2011, you give your niece, Mary, a cash gift of $ 8,000. It is your only gift to her this year. You pay the $ 15,000 college tuition of your friend, David. You give your 25 year-old daughter, Lisa, $ 25,000. You also give your 27 year-old son, Ken, $ 25,000. You have never given a taxable gift before.
Apply the exceptions to the gift tax and the unified credit as follows:
1. Apply the educational exclusion. Payment of tuition expenses is not subject to the gift tax. Therefore, the $ 15,000 tuition payment on behalf of David is not a taxable gift.
2. Apply the annual exclusion. For 2011, the first $ 13,000 you give someone is not a taxable gift. Therefore, your $ 8,000 gift to Mary, the first $ 13,000 of your gift to Lisa, and the first $ 13,000 of your gift to Ken are not taxable gifts.
3. Apply the unified credit. The gift tax on $ 24,000 ($ 12,000 remaining from your gift to Lisa plus $ 12,000 remaining from your gift to Ken) is $ 4,680. Subtract the $ 4,680 from your unified credit of $ 1,730,800 for 2011. The unified credit that you can use against the gift or estate tax in a later year is $ 1,726,120.
You do not have to pay any gift tax for 2011. However, you must still file Form 709.
g. Filing a Gift Tax Return
Generally, you need only file a gift tax return in the following circumstances:
i. You gave gifts to at least one person (other than your spouse) that are more than the annual exclusion for the year.
ii. You and your spouse are splitting a gift.
iii. You gave someone – other than your spouse – a gift of a future interest that he or she cannot actually possess, enjoy, or receive income from until some time in the future.
iv. You gave your spouse an interest in property that will be ended by some future event.
You do not have to file a gift tax return to report gifts to (or for the use of) political organizations and gifts made by paying someone’s tuition or medical expenses.
This isn’t a do-it-yourself project. Hire an experienced attorney to make sure that you are adequately protected.