Know the gift tax rules

At Bankrate we strive to help you make smarter financial decisions. While we adhere to strict , this post may contain references to products from our partners. Here’s an explanation for

Scenario: You are financially well-off, maybe even wealthy. You would like to make some significant gifts to people you care about. Plus, you’ve heard that by transferring assets during your lifetime, you can help your estate-tax bottom line. This translates into the double bingo of exercising your generosity and saving taxes at the same time.

Or alternatively, maybe you’re not extremely wealthy, but still feel rather generous and wish to make a substantial gift to a loved one.

If you’re not careful about how you give away your property, the IRS could be among the recipients of your gifts to others. Is this your intention?

The IRS is fond of revenue, and applying a gift tax to certain gifts is just one more way to help satisfy the government’s voracious appetite for money.

Though Congress created the gift tax game, you can learn to play.

The annual exclusion

First, let’s establish a few definitions. A gift is a gratuitous transfer of value. Something is given, and nothing — or something less than the value of what was given — is received in return. If the gifting party, the “donor” in tax lingo, receives something back from the recipient (the “donee”), that portion of the transfer is not a gift. It’s a sale and the income tax system may step in.

Before you get too concerned about having to pay gift tax, rest assured that for most folks, this tax is not a worry. Some taxpayers might even consider the IRS to be somewhat benevolent in this particular area because tax isn’t imposed until a donor makes one or more gifts to a donee within a calendar year that, in 2007, exceeds $12,000. Gifts within this amount are called “annual exclusion gifts.” Better yet, you can make $12,000 gifts to as many different donees as you want each year and then start making gifts all over again Jan. 1 of the next year.

How the annual exclusion works:

If you want to make a $12,000 gift of cash, securities and so forth this year to each of your three children, there is no gift tax on the transfer. On Jan. 1, you can make annual exclusion gifts again to the same recipients.

Because this tax is indexed for inflation, in the past, it has increased every two or three years in $1,000 increments. As long as the donee has full ownership and possession when the gift is made, the transfer is not taxable, period.

And now, although hard to believe, there’s more IRS indulgence. Even if you exceed the annual exclusion amount to a donee, you don’t have to actually pay the IRS until you’ve made gifts totaling an aggregate of more than $1 million during your lifetime. However, you will have to fill out Form 709 each year your gift to a recipient exceeds the annual exclusion amount.

Here’s an example of when the gift tax applies:

In simplified terms, suppose instead of gifting $12,000 this year to each of your three children, you give them $500,000 each, for a total of $1.5 million. After you subtract three annual exclusions ($1,500,000 – $36,000) you have made a gift of $1,464,000. Because you have a $1 million gift tax lifetime exemption, the only taxable portion of your $1.5 million of gifts is $464,000 ($1,464,000 – $1 million).

By the way, donees need not worry about paying income tax on the value of the gift you make. However, there will be income tax consequences for the donee on any interest, dividends or rental income the gifted property generates after the transfer.

Just for the sake of argument, let’s suppose you want to make a gift that’s worth more than the annual exclusion amount this year. Not only do you NOT want to pay gift tax, you don’t want to tap into your $1 million exemption at all. Well, although a little tax creation called “gift splitting” is not specifically addressed in your wedding vows, your spouse can come to the rescue by stretching the value of your gift and simultaneously eliminating gift tax.

Gift splitting allows a married couple to combine their annual exclusion amounts even if only one spouse springs for the gift. So, if you’re married and the gift isn’t worth more than $24,000, you’re in luck.

How gift splitting works:

Sarah would like to transfer $24,000 this year to her son from a prior marriage. If her husband Sven consents, Sarah can make the $24,000 transfer from her own separate account without any gift tax consequences.

Consent is demonstrated by filing a gift tax return, Form 709, by April 15 in the year after the year of the gift. Once gift splitting is elected, all gifts made by a husband and wife for that year are treated as being split.

Taking gift splitting a step further:

If Sarah transfers $100,000 to her son, the $76,000 excess over the two annual exclusion amounts of $24,000 is also split. Therefore, Sarah and Sven have chipped in $38,000 ($76,000 ? 2) from their individual exemptions of $1 million — leaving them each with a remaining exemption of $962,000.

When you exceed $1 million

OK, what if you’re “there” — you owe gift tax. How bad is it? Well, it’s not pretty. For gifts, the first dollar of tax imposed above the exclusion amount is paid at a marginal rate of 41 percent. And depending on the value of the gift, the rate can be as high as 45 percent.

How the gift tax works:

Assume you already used your annual exclusion to the donee when you make a gift of $1.1 million. The transfer exhausts your $1 million exemption and the $100,000 excess requires you to spring for an extra “gift” to Uncle Sam — to the tune of (cough, cough) $41,000 — say it ain’t so …

This is an outcome no one wants. Can this kind of result be avoided or at least minimized? Is it better to gift certain assets rather than others?

Gift planning can help

There are numerous gift-selection factors that can soften the tax impact. It goes without saying, of course, that the selection of assets for gifting must primarily depend on the donor’s particular goals and circumstances.

Here are some things to think about when choosing assets to gift:

  • Is the property likely to appreciate in value? A transfer of appreciating property removes the future appreciation from the donor’s estate so it’s not there for the estate tax. However, there’s a tradeoff here if you give property while alive as opposed to after your death. If you wait until your death to bequeath the property, the recipient gets a tax benefit: a step-up in basis to the fair market value of the property as of the date of death. This generally results in the estate beneficiary having less taxable gain on the asset when and if it is later sold.
  • Is the donee in a lower income tax bracket than the donor? If high-income-producing property is transferred to a lower bracket family member, income shifting may be achieved. In other words, when the donee takes ownership of the high income-producing property, overall income taxes are reduced from the perspective of the family unit.
  • Is the property subject to indebtedness? A gift of property subject to indebtedness that’s greater than its cost to the donor could cause the donor to realize capital gain. For example, suppose a donor makes a gift of a building that cost the donor $10,000. The building appreciated to $100,000 and had a $70,000 mortgage. The gift results in an income tax gain to the donor on the difference between the debt outstanding at the time of transfer ($70,000) and the donor’s basis ($10,000). In this case, the gain is $60,000, and it is realized at the time the gift becomes complete.
  • Does the property have a sale price lower than the donor’s basis in the property? If so, the donor should consider selling the property to take advantage of the loss deduction for income tax purposes and either gift the sale proceeds or perhaps select other property to gift.
  • Is the donor likely to need or want to use the property in the future? Or is gift likely to cause the donor any financial concerns or reduce the donor’s customary standard of living? If so, this property would not make a good gift choice.
  • Does the donor have expectations or concerns about the donee’s ability to manage or invest the gift? If so, the donor may be better off setting up a trust for the donee — which is a topic for another column.
  • Is the donor concerned about equalizing the value or nature of gifts to donees such as children or grandchildren? If equalization of value matters to the donor, a trust arrangement could solve the problem. If it’s the equality of the nature of gifts that’s bothersome, a solution may prove more difficult. One solution: The asset could be sold and the proceeds divided equally amongst the donees. Donors have also been known to have donees draw straws — a last resort.
  • Is gifting different assets likely to cause conflicts? Arranging a family discussion during which the donor explains his gifting reasons may prove helpful in discouraging conflicts among donees. Solutions to the equalization issues above could also apply here.
  • Is the donor concerned about the stability of the donees’ marriages or the potential for future divorce? If so, be mindful that the departing spouse may be entitled to half the gift value.
  • Is the donor worried about the donees having creditors’ claims? If so, making gifts to an irrevocable trust for the benefit of the donees (trust beneficiaries) makes it difficult for creditors to reach the assets.

Who knew that being generous could be so complicated? But when aspects of the gift tax are known and some proper planning is reviewed, gift tax can be minimized and possibly avoided altogether.