People make gifts for many reasons. Most gifts are not tax-motivated. But it's important to understand the tax rules surrounding gifts so that you do not inadvertently create tax problems.
If you have a taxable estate, gifting over time can be a simple and effective strategy to reduce estate taxes in a meaningful way and increase the wealth transferred to your partner or other 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
There is an unlimited marital deduction available for gifts or transfers between spouses (referred to as "marital deduction gifts").
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. These individuals may include 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 do you owe no gift tax 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 a $14,000 annual exclusion gift.
If you are likely to be subject to federal estate tax, implementing a gifting program has double benefits:
First, you remove the assets from your taxable estate and transfer them to your partner or other beneficiary completely tax free.
Second, gifting also removes the future growth of the gifted assets from your estate. This is a powerful estate tax benefit.
Let's see why gifting is advantageous for the individuals who would be subject to estate tax.
Assume, for example, a couple where one nonmarried partner owns a majority of the assets and would like to shift or transfer some of his or her wealth to the less wealthy partner.
The individual with the higher net worth can give a partner $14,000 each year, free of estate tax. Without gifting, the $14,000 would remain in the taxable estate and could be subject to a 40% estate tax, leaving the surviving partner with just $8,400. Keep in mind, the recipient may be your partner, other family members or even other beneficiaries you wish to include in your gifting program.
Remember, this is only an issue if the wealthier partner's estate exceeds the federal estate tax exclusion of $5,490,000 (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 a partner, and still gift $14,000 to that partner in the same year. You can also use this strategy with children or any other beneficiary you choose.
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 $5,490,000 in 2017. For example, if an individual gifts the entire $5,490,000 lifetime gift exclusion and dies this year, the entire remaining estate would be subject to estate tax. In effect, because the entire exclusion was used up during lifetime, everything that transfers at death would be subject to estate tax.
For example, if you give your partner or 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.
Should you save your exclusion amount to use at death instead of on lifetime gifts? Not necessarily.
The benefit of using your lifetime exclusion is that all future appreciation on the gifted asset is removed from your taxable estate. For example if the $100,000 gift shown in this example appreciates to $200,000 before you die, you would have transferred $200,000 to your loved one tax free, yet you only used $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 is 40% of the amount over the $5,490,000 limit). As a result, gifts of larger assets such as vacation homes, interests in businesses, or perhaps unique items such as artwork, may be considered.
Be sure to work closely with your attorney and CPA if you are considering a large lifetime gift.
If you are considering gifting, a frequent question is whether to give cash or appreciated securities.
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 may eliminate capital gain tax 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 maximum long-term capital gain tax is 20%, while the estate tax is 40%. It is also important to be aware of the Medicare surtax of 3.8% that will apply to net investment income for single taxpayers with modified adjusted gross income above $200,000, or married taxpayers with adjusted gross income 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 in loss positions. 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.