How is the Gift Tax Calculated?

Understanding the Lifetime and Annual Gift Tax Exemptions

Father and son using digital tablet on sofa
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The federal gift tax applies to all gifts you make during your lifetime. Sound intimidating? Relax. Every U.S. citizen is allowed a lifetime exemption from paying the gift tax, so you'd have to give away a considerable amount of money or property before you'd owe it. Gifts are only taxed when their total value exceeds what you're permitted to give away during the course of your entire life, which is $5.49 million as of 2017.


The Annual Gift Tax Exemption 

The lifetime exemption from paying the gift tax intersects with another annual exemption. The annual exemption allows you to make gifts of up to $14,000 per year per person tax-free as of 2017. These gifts don't count against your $5.49 million lifetime exclusion. The lifetime exclusion only kicks in when you exceed this amount. 

Technically, you must report gifts over this annual exclusion to the IRS on Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return. This records the overage. Eventually, at the end of your life when your estate settles, all these overages are added up and applied to the lifetime exemption. If your gifts exceed the lifetime exclusion, the applicable tax rate tops out at a walloping 40 percent for estates of this value as of 2017. 

The Exemption Is a "Unified" Credit 

Now here's where it gets a little tricky. The Internal Revenue Service lumps together all gifts you make during your lifetime with gifts you make as bequests from your estate when you die.

Therefore, the gift tax and the estate tax share this same $5.49 million exemption under the umbrella of something called the unified tax credit. If you exceed your annual exemptions to the tune of $1 million during your lifetime, you'll have only $4.49 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.

Of course, $5.49 million is a lot of money, and only 0.2 percent of Americans owed the IRS any estate taxes in 2013, according to a 2015 government report. This works out to just one out of every 500 deceased citizens. 

A Gift Tax Example

If a father makes a one-time gift of $114,000 to his son for the purchase of a home, $14,000 of that gift is free and clear of the federal gift tax. The remaining $100,000 is a taxable gift and would be applied to his lifetime exemption. 

But if the father gifts his son $14,000 in December, then gives him an additional $100,000 in January, the December gift is free and clear and only $86,000 of the subsequent $100,000 counts against his lifetime exclusion — $100,000 less that year's annual $14,000 exclusion. Remember, the annual gift exemption is per person per year. You can give this much away 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 $86,000 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 about $5.4 million of the unified tax credit left to shelter his estate. 

Not all Gifts Are Taxable 

Another important consideration is that not all gifts are taxable. Dad could have paid his son's tuition bills or medical expenses in any amount without incurring a gift tax, provided he gave the money directly to the learning institution or the medical facility, not to his son. 

Exemptions Increase Periodically 

These exemptions increase periodically, too, to keep pace with inflation. The 2017 lifetime exemption increased from $5.45 million in 2016, although the annual exemption has been stuck at $14,000 since 2013. 

The bottom line is that the great majority of us can give to our heart's content with no tax issues to worry about.