The United States tax system contains three federal transfer taxes: gift tax, estate tax, and generation-skipping transfer tax. The objective of this three-part system is to prevent individuals from giving away very large sums of money, valuables, or property without paying taxes. For this post, the focus is on gift tax rules. While the rules surrounding gifts can be complicated, we’ll narrow our scope to the basic gift tax rules that the average American may face during their lifetime.
Gifts are defined as the transfer of a property interest for less than adequate and full payment. In other words, a gift occurs whenever a gratuitous transfer of benefit is conferred from one owner to a new owner. It is important to note that gift tax rules do not prevent or limit the ability to make gifts. Rather, they determine the tax treatment of the gift. We’re commonly asked by recipients of large gifts what they’ll have to pay in taxes. Regardless of the gift type or amount, any gift tax owed is the responsibility of the person who gave the gift, not the person who received it.
To understand gift taxes, we must first explain the “lifetime exclusion,” which is also known as the “unified credit”. The lifetime exclusion is the value of property that may be given away by an individual without incurring gift or estate taxes. In 2014, each U.S. citizen can gift $5,340,000 during their lifetime. Whenever gifts are given that are not covered by one of the exemptions below, the amount given is subtracted from the lifetime exclusion amount. Due to the large amount of the lifetime exclusion, the vast majority of Americans will never pay gift taxes under current laws.
As with many tax-related principles, the IRS approaches gift taxes from an exemption viewpoint. In other words, the IRS considers any gift a taxable gift and then provides exceptions. The exceptions are below.
- Gifts that are below the annual exclusion amount. Each year, any individual may make gifts to as many people as he or she chooses without notifying the IRS of the gift or subjecting the donor to gift tax, as long as the value of the gift is less than the annual exclusion amount. In 2014, the annual exclusion amount is $14,000 per recipient. Gifts above the annual exclusion amount aren’t automatically taxable due to the availability of the lifetime exemption. Only after the exhaustion of the lifetime exemption do gifts above the annual exclusion amount result in payment of gift taxes. For example, imagine that John Donor wants to give his five children cash gifts. John can give each child up to $14,000 without reporting the gift.
- Educational and medical exclusion. The IRS allows taxpayers to give unlimited gifts on behalf of individuals for medical care, dental care, health insurance premiums, or education. Gifts must be made directly to the institution, like the hospital or college, on behalf of the individual. The amounts are not subject to the annual exclusion and do not count against the donor’s lifetime exclusion amount.
- Gifts to spouses. The tax provisions provide for an unlimited amount of gifts between spouses without requiring documentation, as long as the receiving spouse is a U.S. citizen. If the receiving spouse is not a citizen of the United States, a gift tax return must be filed every year that gifts to the spouse total more than $145,000 (subject to inflation). Additional gifts above the threshold in any one year result in the amount being offset by the lifetime exclusion amount.
- Gifts to political organizations.
Spouses are given one additional special privilege related to gift tax laws. Spouses may elect to split gifts in order to give more money. In 2014, splitting gifts means that a married couple may give $28,000 to any individual during the calendar year. If electing to split gifts, the couple must file a gift tax return and report the gift to the IRS.
In any year in which gifts are given that do not qualify for any of the above exceptions, taxpayers must file an additional form, form 709, with their taxes. Want to learn more about gift tax rules? Check out the IRS’s frequently asked questions page here.
Understanding and complying with gift tax rules can be challenging. If you’re considering embarking on a gifting strategy, we encourage you to consult with the appropriate experts, including your financial advisor, your estate planning attorney, and your tax professional.