How Is the Gift Tax Calculated?
Most people don't have to worry about paying this tax
Technically, the federal gift tax applies to most gifts you make during your lifetime—from that $5 bill you might give a homeless person on the street to a substantial down payment on a house for your child. You're supposed to keep track of all of it. Does that sound intimidating? Take a deep breath and relax. It's not as bad as it sounds.
You Have Two Options
Every taxpayer has two options for dodging the gift tax. The first is an annual exclusion, and you're also allowed a lifetime exemption.
You'd have to give away a considerable amount of money or property before you'd owe this tax. Gifts are only taxed when their value exceeds the lifetime exemption—the amount you're permitted to give away during the course of your entire life, which is $11.58 million as of 2020.
What Counts 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.
Another important consideration is that not all gifts are taxable. 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.
Gifts to spouses who are U.S. citizens are tax-free as well.
The Annual Gift Tax Exclusion
It all starts with the annual exclusion, which lets you make gifts of up to $15,000 per year per person tax-free as of 2020. These gifts don't count against your $11.58 million lifetime exemption.
The lifetime exemption only kicks in when you exceed this annual amount in a given year.
The key words 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.
When and Why You Must File a Gift Tax Return
You must report gifts over the annual exclusion to the IRS on Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return. This records how much you've gone over the annual exemption each year—the amounts that count against your lifetime exemption.
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.
The Lifetime Exemption Is a "Unified" Credit
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 lifetime exemption of $11.58 million, the tax rate currently tops out at a whopping 40 percent for estates.
If you exceed your annual exclusions to the tune of $1 million during your lifetime, you'll have $10.58 million left to shelter your estate from estate taxes when you die.
The value of your lifetime gifts comes off the lifetime exemption first; then any exemption that is left over is applied to your estate's value.
Of course, $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 isn't entirely without a heart, and it 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.
Exemptions Increase Periodically
The lifetime exemption increases periodically to keep pace with inflation and due to changes in legislation. The 2017 lifetime exemption of $5.49 million increased from $5.45 million in 2016 with inflation adjustments, then it went from $5.49 million to $11.18 million in 2018, thanks to the Tax Cuts and Jobs Act and another inflation adjustment.
The annual exclusion was stuck at $14,000 from 2013 through 2017 before it increased to $15,000 in 2018, where it has remained into 2019 and 2020. It can only change in $1,000 increments, and it does not have to do so every year.
The bottom line is that the great majority of us can give to our heart's content with no tax issues to worry about.
Internal Revenue Service (IRS). "Publication 559: Survivors, Executors and Administrators: Estate and Gift Taxes," Page 25. Accessed Feb. 17, 2020.
Internal Revenue Service (IRS). "What's New - Estate and Gift Tax." Accessed Feb. 17, 2020.
Internal Revenue Service (IRS). "Frequently Asked Questions on Gift Taxes." Accessed Feb. 17, 2020.
Internal Revenue Service (IRS). "About Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return." Accessed Feb. 17, 2020.
Internal Revenue Service (IRS). "Estate Tax." Accessed Feb. 17, 2020.
Center on Budget and Policy Priorities. "Ten Facts You Should Know About the Federal Estate Tax." Accessed Feb. 17, 2020.
Internal Revenue Service (IRS). "Instructions for Form 706: Time for Payment." Accessed Feb. 17, 2020.
Internal Revenue Service (IRS). "Publication 559: Survivors, Executors and Administrators: Estate and Gift Taxes," Page 26-27. Accessed Feb. 17, 2020.