How Is the Gift Tax Calculated?

Most people don't have to worry about paying this tax

Image shows one person giving a gift to another, standing in front of a stack of money. Text reads: "What counts as a 'gift'? IRS considers a 'gift' any transfer of cash or property in which the donor doesn't receive something of equal value in return. Not all gifts are taxable; example: making a loan to a friend without charging him interest (and then forgiving the loan)"

Image by Ran Zheng © The Balance 2020

While taxpayers should technically keep track of the gifts they make during their lifetime, you can take a deep breath if that sounds intimidating. In reality, most gifts legitimately fall under the radar of U.S. federal gift tax rules.

In fact, you'd have to give away a considerable amount of money or property before you'd owe any taxes. The idea behind it is to prevent people from giving their assets away ahead of their death in order to avoid the estate tax when they die.  

There are a few ways you can avoid paying taxes on a gift. For one, there are certain specific exclusions based on the type of gift or the recipient. In addition, the Internal Revenue Code provides for an annual exclusion—an amount per year that’s automatically excluded from the tax—as well as a lifetime exemption amount that factors in if you exceed your annual exclusion.

Here’s how it all shakes out and how gifts are defined when it comes to Uncle Sam.

The U.S. federal gift tax is imposed on cash and properties that individuals give to others. It's paid by the donor, not the beneficiary of the gift.

What Qualifies As a Gift?

The Internal Revenue Service considers a gift to be virtually any transfer of cash or property in which the donor doesn't receive something of equal value in return. If you give someone cash with the understanding that he does not have to pay you back, that's a gift. If you sell someone a $300,000 home for $150,000, you've made her a gift of $150,000. 

This is all based on the IRS definition of "fair market value." Cash is what it is, so there's rarely any doubt there. As for that house, the IRS says its fair market value is what someone could be expected to pay for it if neither the buyer nor the seller were under any sort of duress to commit to the transaction.

The IRS definition of a gift can even hide in places you might not expect. If you make a loan to a friend without charging him interest, the IRS says that's a gift—particularly if you later forgive the debt. And if you put your adult child on your bank account as a joint owner, perhaps so she can help you take care of your financial business, guess what? She's just given you a taxable gift.

Which Gifts Don’t Count?

Certain gifts aren't subject to the gift tax. Dad could pay his son's tuition bills or medical expenses in any amount without incurring a gift tax, provided he gives the money directly to the learning institution or the medical facility, not to his son.

There’s also an unlimited marital deduction that applies to all gifts made by a U.S. citizen to a spouse who is also a U.S. citizen. With a few exceptions, you can give your husband or wife as much as you like without paying a gift tax. Or, if the recipient spouse is not a U.S. citizen, you can give up to $155,000 in cash or property. This limit is indexed for inflation.

You can give to qualified charitable organizations and to some political organizations without incurring the tax as well.

Excluded and Exempt Amounts

Annual Gift Tax Exclusion

The annual exclusion lets you make gifts of up to a certain amount per year per person, tax-free. For both the 2019 and 2020 tax years, this amount is $15,000. (It can only change in $1,000 increments, though it does not have to do so every year.)

The keywords here are "per person." If your son and his spouse want to buy a house and you want to give them $30,000 for a down payment, you can do that without paying a gift tax. You can attribute $15,000 for that year to each of them. The IRS doesn't care whether they both spend the money on the same thing.

And here's another bonus if you're married: You and your spouse are each entitled to a $15,000 annual exclusion. Technically, you could give your son and his spouse $60,000 toward that house—$15,000 to each of them from both you and your spouse.

If the total doesn't exceed $15,000, gifts given as either lump-sum amounts or as a series of amounts to the same person over the course of one tax year aren't taxed. Likewise, you could give your daughter $15,000 in December and another $15,000 in January without incurring the tax because the gifts occurred in two separate years.

The annual gift tax exclusion is applied individually, based on each gift recipient. In the same year, you can give $15,000 in cash to your daughter, a $15,000 car to your son, a $15,000 diamond ring to your best friend, and $15,000 worth of stock to each of your grandkids. None of these are taxable.

Lifetime Gift Tax Exemption

Even if you give someone more than $15,000 in a year, you won’t necessarily have to pay gift taxes, thanks to the lifetime exemption. This is the total amount you can give away tax-free over the course of your entire lifetime, and it’s $11.58 million as of the 2020 tax year ($11.4 million for the 2019 tax year.)

It's a collective cap rather than by person or by year, and it's in addition to the annual exclusion. If you gave your daughter $30,000 all at once, $15,000 of that would be tax-free under the annual exclusion and the remaining $15,000 could be covered by the lifetime exemption, if you elect this option.

You must report gifts over the annual exclusion to the IRS on Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return. This is a record of how much you've gone over the annual exclusion each year. These overage amounts count against your lifetime exemption.

The Tax Cuts and Jobs Act

  • The TCJA spiked the exemption up to $11.18 million in 2018—effectively doubling it from the year before. (Since then it has been adjusted a bit more to keep pace with inflation.)
  • While the TCJA will expire at the end of 2025 unless Congress renews the legislation, people that take advantage of the large increase through 2025 will not be adversely impacted after that, even if it plummets back to the $5 million range, according to the IRS.

The lifetime exemption for the gift tax is shared with the federal estate tax, so your lifetime gifts reduce the amount of exemption you have left to later shield your estate from taxation.

In other words, the IRS lumps together all gifts you make during your lifetime with gifts you make as bequests from your estate when you die. The gift tax and the estate tax share this same $11.58 million exemption under the umbrella of something called a unified tax credit.

Eventually, at the end of your life when your estate settles, all these annual overages are added up and applied to your lifetime exemption. If your excess gifts plus the value of your estate exceed the $11.58 million, the tax rate currently tops out at a whopping 40% for estates. 

Conversely, if you exceed your annual exclusions by just $1 million during your lifetime, you'll have $10.58 million left to shelter your estate from estate taxes when you die.

Of course, you can go ahead and pay the tax on these gifts when you file the gift tax return. You don't have to let them count against your lifetime exemption. 

All that said, $11.58 million is a lot of money. Only two out of every 1,000 estates owed any estate tax in 2017—and the annual exemption that year was roughly half the 2018 exemption, just $5.49 million.

A Gift Tax Example

If a father makes a gift of $115,000 to his son for the purchase of a home, $15,000 of that gift is free and clear of the federal gift tax, thanks to the annual exclusion. The remaining $100,000 is a taxable gift and would be applied to his lifetime exemption if he chose not to pay the tax in the year he made the gift. 

But if the father gifts his son $15,000 on Dec. 31, and then gives him an additional $100,000 on Jan. 1, the December gift is free and clear and only $85,000 of the subsequent $100,000 counts against his lifetime exclusion—$100,000 less that year's annual $15,000 exclusion. Remember, the annual gift exemption is per person per year. 

You can give the annual exclusion amount to any one person every single year and never dip into your lifetime exemption. If the father doesn't want to pay the gift tax on the $85,000 in the year the gift is made, he can reduce his lifetime gift tax exemption by this amount. Despite his significant generosity, Dad would still have $11,495,000 of the unified tax credit left to shelter his estate. 

Another Option for Payment 

The IRS encourages generosity to some extent, giving you yet a third option. If you give gifts in excess of the annual exclusion, a special rule lets you spread their value out over five years, another way of effectively paying the tax now so that you don't have to dip into your lifetime exemption.  

Let's go back to that $115,000 Dad gave his son. The first $15,000 is tax-free, thanks to the annual exclusion. The second $15,000 is tax-free, thanks to the following year's annual exclusion. Now Dad can shave an additional $60,000 off his taxable gift, stretching that extra $100,000 over a total of five years: $15,000 for the Jan. 1 gift and $15,000 in each of the next four years.

He's whittled his taxable gift down to just $25,000, on which he can either go ahead and pay the gift tax or let it count against his lifetime exemption. 

Of course, this means he can't give his son any more tax-free gifts, at least for five years. And he must still file a gift tax return, in this case, to let the IRS know that he's electing this option.

The great majority of us can give to our heart's content with no tax issues to worry about. However, if the value of your gifts exceeds the lifetime exemption from the IRS, you have choices to make. The IRS will collect now, or it will collect later...but it will collect.

Article Sources

  1. Internal Revenue Service. "Frequently Asked Questions on Gift Taxes." Accessed April 30, 2020.

  2. Internal Revenue Service. "2019 Instructions for Form 709: United States Gift (and Generation-Skipping Transfer) Tax Return." Page 8. Accessed April 30, 2020.

  3. Internal Revenue Service. "2019 Instructions for Form 709: United States Gift (and Generation-Skipping Transfer) Tax Return," Page 3. Accessed April 30, 2020.

  4. Internal Revenue Service (IRS). "Publication 559: Survivors, Executors and Administrators: Estate and Gift Taxes." Page 26-27. Accessed April 30, 2020.

  5. Internal Revenue Service. "What's New - Estate and Gift Tax." Accessed April 30, 2020.

  6. Internal Revenue Service. "Estate and Gift Tax FAQs." Accessed April 30, 2020.

  7. Federation of American Scientists. "Recent Changes in the Estate and Gift Tax Provisions." Page 1. Accessed April 30, 2020.

  8. Center on Budget and Policy Priorities. "Ten Facts You Should Know About the Federal Estate Tax." Accessed April 30, 2020.

  9. Internal Revenue Service. "Instructions for Form 706: Time for Payment." Accessed April 30, 2020.