One aspect of tax planning that many individuals may not be familiar with is the taxability of gifts. Separate and apart from any estate taxes that may be due when you transfer assets after you pass away, gifts that you make during your lifetime may increase your federal tax liability as well.
The General Rule on Gift Taxes.
Unless a tax exclusion applies, making a gift to another person will generally trigger a tax liability in the year in which the gift is made. A “gift” is defined by the IRS as any transfer to another individual where the transferee does not provide equivalent financial value back to the transferor.
Of course, individuals have many reasons for making gifts before they pass away. Obviously many are going to want to see for themselves the benefits that accrue to the gift beneficiaries. Furthermore, foregoing gifts while still alive means leaving a larger estate, which could trigger tax liabilities that would effectively reduce the value of the estate that gets passed down to your heirs.
Individual Gift Tax Exclusions.
Fortunately, the tax code contains several provisions that exclude certain types of gifts from federal tax. Every recipient is subject to an annual exclusion amount, such that the aggregate amount of all gifts from you to that individual will not be subject to taxation if the amount is below the exclusion. For both 2020 and 2021, the annual gift-tax exclusion is $15,000 per donor, per recipient. This means that you can make many different gifts without triggering any tax liability, provided that each domain receives no more than $15,000.
While it might seem like the lifetime exclusion would easily cover all gifts that an individual could make, some taxpayers find that it’s important to document all of their financial gifts so that they can be sure not to exceed this lifetime tax-free gift cap. This is true because the applicability of the estate tax is determined based on the size of your estate after taking into account the prior taxable gifts you’ve made. In other words, if you made gifts during your lifetime in excess of the exclusion that was in force during the applicable tax year, then the amount that you can pass on before the estate tax applies is correspondingly reduced.
Other Gift Tax Exclusions.
As noted above, the exclusion for tax-free gifts is capped at $15,000. In addition, there are certain types of gifts that will not trigger any current year taxation, irrespective of the amount. These are:
- gifts made for the purpose of paying an individual’s higher education tuition expenses (but not room, board, books or other associated educational expenses);
- gifts made for the purpose of paying an individual’s medical expenses;
- gifts made to your spouse; and
- gifts to a political organization for their own use.
The gift tax rules can be a challenge for taxpayers who are facing them for the first time. If you believe that the gift tax provisions may apply to your situation, the best course is probably to consult with a professional advisor.