People make gifts for many reasons. Although most are not tax-motivated, it’s important to understand the tax rules surrounding gifts so you don’t inadvertently create tax problems.
If your estate is large enough to potentially incur estate taxes, gifting over time can be a simple and effective strategy to reduce estate taxes and increase the wealth transferred to your beneficiaries.
In this section you will learn about:
- Marital deduction gifts
- Three types of gifts (if no marital deduction is available)
- The type of assets you should consider when making gifts
Marital deduction gifts
There is an unlimited marital deduction available for gifts or transfers between spouses (referred to as “marital deduction gifts”). In other words, there is no limit on the gifts you can give your spouse without incurring gift taxes. In order to qualify for the unlimited marital deduction, the spouse receiving the gift must be a U.S. citizen.
Three types of gifts (if no marital deduction is available)
There are three types of gifts that anyone can make without gift tax implications: annual exclusion gifts, education and medical exclusion gifts, and applicable exclusion gifts (sometimes referred to as lifetime exclusion gifts).
Annual exclusion gifts. You may gift up to $14,000 each year to as many individuals as you want, including your partner, children, other family members, or even non-family members. To qualify for the annual exclusion, you must give the recipient a present interest in the gifted asset.
Not only will you owe no gift taxes on an annual exclusion gift, but your beneficiary will owe no income tax (at least not until your gift starts earning income). Keep in mind that you do not receive an income tax deduction for an annual exclusion gift.
If you are likely to be subject to federal estate tax, implementing a gifting program has double benefits:
- You remove the assets from your taxable estate and transfer them to your beneficiary tax free.
- Gifting removes any future growth of the gifted assets from your estate. This can be a powerful estate tax benefit.
Let’s see why gifting is advantageous for individuals who may be subject to estate tax.
Assume, for example, a non-married couple where one partner owns a majority of the assets and would like to shift or transfer some wealth to his or her partner. He or she can give the partner $14,000 each year free of gift tax. Otherwise, the $14,000 would remain in the wealthier partner’s taxable estate and could be subject to a 40% estate tax, leaving the surviving partner with just $8,400.
Remember, this is only an issue if the wealthier partner’s estate exceeds the $5,490,000 federal estate tax exclusion (or the state exclusion amount if your state has an estate tax) and if no marital deduction is available.
Education and medical exclusion gifts. To qualify for education and medical exclusion gifts, you must make payments directly to the educational institution or medical service provider on behalf of an individual. So you can pay tuition or medical expenses for an individual and still gift $14,000 to him or her in the same year. You can use this strategy with a partner, children, or any other beneficiary.
Applicable exclusion gifts. Lifetime gifts in excess of your $14,000 annual exclusion, as well as any education or medical exclusion gifts, do not incur a gift tax until they exceed your applicable exclusion (this amount is also known as your lifetime exclusion). In 2017, each individual has a $5,490,000 lifetime gift exclusion amount. The value of these gifts will effectively reduce your estate tax exclusion amount, which is also $5,490,000 in 2017.
For example, if you give a child a $100,000 gift, $14,000 is treated as an annual exclusion gift and $86,000 reduces your lifetime exclusion amount to $5,404,000. You will need to file IRS Form 709 when you gift any portion of your lifetime exclusion, but you will not owe a gift tax until your cumulative lifetime exclusion gifts exceed $5,490,000. Or if an individual gifts $5,504,000 this year, $14,000 would be treated as an annual exclusion gift and the remaining $5,490,000 would use up his or her entire lifetime gift exclusion. If he or she dies in 2017, the whole remaining estate would be subject to estate tax because the entire exclusion was used up during his or her lifetime.
Should you save your exclusion amount to use at death instead of on lifetime gifts? Not necessarily.
One benefit of using your lifetime exclusion is that any future appreciation on the gifted asset is removed from your taxable estate. For example, if the $100,000 gift shown in the first example above appreciates to $200,000 before you die, you would have transferred $200,000 to your loved one tax free, yet you used only $86,000 of your estate tax exclusion.
In future years, the applicable exclusion amount will be indexed to inflation. This increase provides individuals with additional gifting potential. For partners, grandparents, parents, and others who may be considering a gifting program this year (or perhaps enhancing their existing program), larger gifts may be made without incurring gift tax (which starts at 40% on amounts over the $5,490,000 exclusion). As a result, gifts of larger assets such as vacation homes, interests in businesses, or unique items like artwork, may be considered.
Be sure to work closely with your attorney and CPA if you are considering a large lifetime gift.
Assets to consider when gifting
If you are considering gifting and own securities that have appreciated in value since you purchased them (“appreciated securities”), you need to determine whether to gift the securities or cash.
If you are considering a gift of appreciated securities, weigh the advantages and disadvantages. If you hold your securities until your death, the tax basis is “stepped up” to the property’s fair market value on the date of your death. This “step up” may reduce or even eliminate capital gain taxes but subject securities to possible estate tax. If, on the other hand, you gift the securities while you’re still living, the asset is removed from your taxable estate, but the recipient takes on your cost basis, so you also transfer a potential capital gain tax liability.
Currently, the long-term capital gain tax is 15% or 20% while the maximum estate tax is 40%. It is also important to be aware of the Medicare surtax of 3.8% that applies to net investment income for single taxpayers with a modified adjusted gross income (MAGI) above $200,000 or married taxpayers with an MAGI above $250,000. If the recipient of a gift has income above these thresholds, a potential capital gain could be subject to this surtax.
In most cases, it is not advantageous to gift assets that are worth less than what you paid for them. When you gift assets held at a loss, special basis rules apply and your beneficiaries cannot use the tax loss. You may want to consider selling the stock and giving the beneficiary cash. If you do, you may be able to use the capital loss on your own income tax return.