How Is the Gift Tax Calculated?
A Tax on Gifts Worth More Than $15,000
Taxpayers should technically keep track of the gifts they make during their lifetimes, but 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 this tax. The goal behind the gift tax is to prevent people from giving their assets away before death in order to avoid their estate having to pay an estate tax when they die.
But you can avoid paying a tax on gifts in a few ways. First, some specific exclusions apply based on the type of gift or the giver’s relationship to the recipient. The Internal Revenue Code additionally provides for an annual exclusion—an amount you can give each year that’s automatically excluded from the tax—as well as a lifetime exemption amount that factors in if you exceed your annual exclusion.
The U.S. federal gift tax is imposed on cash and property that individuals give to others. It’s paid by the donor, not by the beneficiary of the gift.
What Qualifies as a Gift?
The Internal Revenue Service considers a gift to be any transfer of cash or property when the donor doesn't receive something of equal value in return. For example, if you give someone cash with the understanding that they don’t have to pay you back, that’s a gift. You’ve made a gift of $150,000 if you sell someone a $300,000 home for $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 was 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. The IRS says it’s a gift if you make a loan to a friend without charging interest, particularly if you later forgive the debt. If you put your adult child on your bank account as a joint owner so they can help you take care of your financial business, you’ve given them a taxable gift.
Which Gifts Don’t Count?
Certain gifts aren't subject to the gift tax. You can pay someone’s tuition bills or medical expenses in any amount without incurring a gift tax if you give the money directly to the learning institution or the medical facility, not to the beneficiary.
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. If you’re a U.S. citizen but your spouse is not, you can give them up to $157,000 in 2020 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
The IRS also lets you gift money or property under any circumstances subject to certain limits. In other words, you just can’t give too much.
Annual Gift Tax Exclusion
The annual gift tax 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 doesn’t have to do so every year.
The key words here are "per person" and “per year.” 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 by attributing $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 you and from your spouse.
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 if the total is under $15,000. 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. For example, you could give $15,000 to your daughter, $15,000 to your son, $15,000 to your best friend, and $15,000 to each of your grandchildren all in the same year. None of these gifts would be subject to the gift tax.
Lifetime Gift Tax Exemption
You won’t necessarily have to pay gift taxes even if you give someone more than $15,000 in a year, thanks to the lifetime gift tax exemption. This is the total amount you can give away tax-free over the course of your entire life, and it’s $11.58 million as of the 2020 tax year. It’s indexed for inflation, so it can be expected to increase somewhat in 2021.
This is a collective cap rather than one broken down 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.
There’s just one catch: This lifetime exclusion is also referred to as the “unified tax credit” because it applies both to gifts you give during your lifetime and the value of your estate when it passes to your beneficiaries after your death. That $11.58 million covers both. If you used up $5.58 million on exempting gifts during your lifetime, you would have only $6 million left to shelter your estate.
That $11.58 million threshold 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.
The Tax Cuts and Jobs Act (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. The TCJA is set to expire at the end of 2025, but the IRS has indicated that taxpayers who take advantage of the large increase won’t be adversely impacted after that, even if it plummets back to the $5 million range.
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. 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.
A Gift Tax Example
If a father makes a gift of $115,000 to his child to help them buy 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 could be applied to the father’s lifetime exemption if he chose not to pay the tax in the year he made the gift.
But if the father gives the child $15,000 on December 31, then gives an additional $100,000 on January 1, the December gift is free and clear. Plus, only $85,000 of the January gift of $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.
The great majority of us can give to our hearts’ content with no tax issues to worry about, but if the value of your gifts exceeds the annual exclusions, you’ll have some decisions to make. The IRS will collect now, or it will collect later...but it will collect.