Are you thinking about sending someone a monetary gift? While your act of generosity is admirable, you may not know that your gift is taxable.
The federal gift tax applies to the majority of donations you’ll make, from handing a homeless person a dollar bill to giving your kids money to put a down payment on an apartment – the IRS requires their cut, and you’re supposed to track all your donations, no matter how small.
Before you start to curse at the state departments audacity to tax all your gifts, it’s not as intimidating as it sounds. Let’s break down everything you need to know about how the gift tax works, and where it applies to your finances.
Every taxpayer has the advantage of exemptions when it comes to the gift tax. The IRS permits you to use both an annual and lifetime exclusion, and you’ll have to gift a significant amount of money or assets before it comes into play.
The IRS only taxes your monetary gifts when they exceed the value of the lifetime exemption, which currently sits at $11.4-million in 2019.
What Does the IRS Consider as a Monetary Gift?
According to the IRS, the definition of a gift includes a transfer of property or cash, where you don’t receive anything of value in return for the transaction. For instance, if you give your daughter a $150,000 cash gift to buy a home, and she registers the deed in her name, then you received no benefit from the donation, making you liable for the gift tax.
Similarly, if you were to sell your daughter one of your homes valued at $300,000, for $200,000, then you’ve made a gift to her totaling $100,000. As a result, you are liable for a gift tax on the $100,000 difference between the list price of the asset, and the price your daughter paid for the property.
The Internal Revenue Service bases asset gifts on fair market value. While a cash gift is hardly disputable, real estate is a different category. The IRS determines fair market value by looking at the list price someone would pay for the property on the open market, and there is no duress involved in the transaction.
The Internal Revenue Service also applies the gift tax to other transactions which you might not expect would be liable. For instance, if you were to loan your brother $50,000, without charging them any interest on the loan, or forgive the debt in a few years – the IRS recognizes this transaction as a gift, and gift tax applies.
Should you register your kids as a joint signatory on your bank account, and they draw money – any withdrawals register as a gift in the eyes of the IRS, and you’ll be liable for the gift tax.
Another common mistake people make with the gift tax comes in the form of wedding gifts. When your daughter gets married, you may want to pay for their honeymoon or the costs of the wedding. Your act of generosity will trigger the gift tax. However, if you decide to pay the creditors yourself, without funneling the cash through your daughter’s bank accounts, then you are no longer liable for the gift tax.
Some Gift Tax Exemptions
There are exemptions available on certain forms of gifts. For instance, if you decide to help your daughter out with paying her college tuition, you are exempt from the gift tax. However, to avoid the gift tax, you’ll need to ensure that you pay the creditor directly. You don’t deposit into her account, as the IRS views this as a third party transaction similar to a gift, regardless if she’s using it to pay off the loan, (see IRS Form 709 for further details).
Another exemption worth noting is that all financial gifts to your spouse, including cash and assets, is tax-exempt, provided your spouse is a U.S citizen.
If the grandparents decide to open a 529 plan to contribute to your daughter’s education, then any money drawn from the plan and given to your daughter for tuition is liable for the gift tax.
However, the IRS allows the grandparents to spread the cost of this one-time gift across their tax returns for 5-years, allowing them to take advantage of the lifetime gift tax exclusion, and they won’t owe anything on the funds, provided it’s within the lifetime exclusion limits.
The Annual Gift Tax Exclusion
As of 2019, the IRS states that the annual gift tax exclusion applies to the first $15,000 you gift to others. If married, then you can double this gift amount to $30,000 to represent both partners in the marriage. Therefore, if your daughter requires a $30,000 down payment for her apartment, you can register a $30,000 joint gift, and you aren’t liable for the gift tax.
You can also gift her and her spouse $15,000 each, and you won’t be held liable for the gift tax by the IRS. In this case, the revenue services don’t have an issue with them both spending the funds on the same item. Technically, spouses are both entitled to the annual exclusion, so you would be able to gift them $15,000 each from both you and your spouse, for a total of $60,000 that’s exempt from the tax.
The annual gift tax exemption does not count against your lifetime exclusion either. The lifetime exclusion limit of $11.4-million only applies if you exceed the $15,000 annual threshold.
Why and When You Should File a Gift Tax Return
You need to file your gift tax before April 15th, as you would with your standard tax return. You report the tax on IRS Form 709, the United States gift and generation-skipping Transfer tax return. This filing provides the revenue services with exactly how much you gift over the year, and if you went over the annual exemption allowance.
If you did gift more than the annual limit, then the additional funds go toward your lifetime exemption amount. When filing your return, you can pay the tax on the outstanding amount, and the IRS won’t count it against your lifetime exemption.
The Lifetime Gift Tax Exclusion Explained
As mentioned, on top of your annual $15,000 exclusion limit, every taxpayer gets an $11.4-million lifetime exclusion from the gift tax as well. Married couples are allowed to double that lifetime limit, resulting in a total lifetime exclusion limit of $22.8-million.
Any annual gifts above the $30,000 limit for married couples will spill over into the lifetime exclusion limit. However, you’ll still need to report any excess to the IRS in your tax return each year. Failure to report could leave you exposed to the IRS charging you fines and penalties on your gifts.
However, if you do your reporting the right way, then any excess above the $30,000 limit for married couples, and the $15,000 threshold for singles spills over into your lifetime exclusion limit. Think of it like placing a cup inside a bucket. You fill up the cup (which represents the annual limit), and any additional funds spill over into the bucket, (the lifetime exemption limit).
As an example of this scenario, if you gift your sister $50,000 in 2019, then you’re liable for the gift tax on the additional $35,00 above the $15,000 limit. However, if you fill out your gift tax return and file it with the IRS properly, then you don’t have to worry about the additional $35,000 as the IRS deducts it from your lifetime exemption.
Using this system, you could continue to gift your sister $50,000 per year, and never have to pay the gift tax until you exceed the $11.4-million limit set in 2019. All the gift tax does, in this case, is track your lifetime exemption limit. As an additional bonus, if you never use up your lifetime exemption limit, then you can use it against any estate taxes when you die and bequeath your assets to your family.
An Example of the Gift Tax in Action
Let’s say that you make a cash gift to your daughter of $65,000 to help her purchase an apartment. Of the total amount, $15,000 is exempt from the annual federal gift tax, and the further $50,000 counts toward your lifetime gift tax exemption, should you choose not to pay the gift tax upon filing that year.
However, if you gift your daughter $15,000 on December 31st, 2019, and then a further $50,000 on January 1st, 2020, The December gift is tax-free, and the $50,000 January gift qualifies for the $15,000 annual exclusion in 2020. Therefore, you only exceed your yearly gift tax in 2020 by $35,000, which counts toward your lifetime exemption limit.
Other Special Exemption Options
While it seems like the IRS is out to tax Americans for anything they can think of, it’s not the case. There is a third special rule exemption available for taxpayers. Should you decide to gift more than your annual exclusion limit, the IRS allows you to take advantage of a special rule that permits you to spread out the gift amount over 5-years.
This special rule provides taxpayers with another means of paying the taxation now, without the need to attribute it towards your lifetime exemption limit.
If we apply this to the previous example, the first $15,000 gift in December remains tax-free thanks to the annual exclusion limit. Of the $50,000 contribution made in 2020, you still get to take advantage of the $15,000 annual exclusion on the second $50,000 amount, leaving you with a balance of $35,000 liable for the gift tax.
The special gift tax rule permits you to spread the remaining $35,000 over the course of the next three years, resulting in no change in your lifetime exclusion limit. However, this means that you will only be able to gift your daughter another $30,000 in the remaining 2-years left in your special rule exemption, and any further gifts over this limit will apply to your lifetime exemption rule.
Periodic Exemption Increases
The Internal Revenue Service periodically adjusts both the annual and lifetime exemption limit to track inflation, and any changes in federal legislation set out by the government. However, sometimes the lifetime exemption limit does not follow either of these indicators.
In 2017, the IRS increased the lifetime exemption limit from $5.45-million in 2016, to $5.49-million. However, in 2018, the IRS made a significant increase in the lifetime exemption limit, from $5.49-million to $11.18 million. This sudden unexpected increase occurred due to the tax cuts offered by the Trump administration, as well as changes in the Jobs Act, and adjustments to the inflation outlook.
The annual exclusion limit for taxpayers floated in limbo from 2013 through to 2017, set at $14,000. In 2018, the IRS increased the yearly exclusion rate to $15,000, which does not in any way reflect the massive upswing in the lifetime exemption rate. The IRS is under no obligation to lift the annual exemption rate each year, and when it does, it typically only does so in $1,000 increments.
Wrapping Up – Key Takeaways
The gift tax is one of the more obscure taxation facility enforced by the Internal Revenue Service. It applies to any cash gifts or changes in asset ownership where no compensation is involved in the transaction.
The gift tax has three exemptions, allowing you to benefit from tax-free gifts throughout the year. The annual exemption rate is $15,000 – as of 2019. The lifetime exemption rate is $11.4-million as of 2019. A third special gift tax exemption allows the taxpayer to spread any additional gifts over the duration of a 5-year term.
If you exceed the annual exemption rate, then the IRS deducts any additional money from your lifetime exemption, provided you file the correct paperwork during filing season. You also have the option to pay your gift tax each year to avoid reducing your lifetime exemption limit.
If you preserve your lifetime exemption limit, it can help reduce the taxes on your estate when you die. Always check with your accountant before filing your gift tax return.