Some people believe that when it comes to gifts, giving cash shows a lack of thoughtfulness. But as anyone who’s ever received a horrible gift knows, many gifts are simply a waste of time and money. So why not give cash and let the recipient buy what they want?
For most of us, gifts are a no-brainer: You give whatever you can afford and let your loved one enjoy it. But if you’re extremely generous, you might have to consider the gift tax. Here’s what you need to know about gift tax rules.
What Does the IRS Consider a Gift?
Leave it to the IRS to take a word that sounds perfectly simple and pleasant and give it a complicated definition. IRS Publication 559 states, “A gift is made if tangible or intangible property (including money), the use of property, or the right to receive income from property is given without expecting to receive something of at least equal value in return.”
By that definition, gifts come into play in many situations. You might give money to a friend or family member to help them out. You might give someone a car, furniture, the use of your vacation home, or an interest in your business. You might even forgive a debt someone owes you. All of those could be considered a gift.
However, don’t confuse generosity with charity. You can deduct gifts to charities if you itemize deductions. Gifts to individuals, however, are not deductible. The recipient does not have to claim the gift as taxable income, and you don’t get a deduction for making the gift.
Pro tip: By using tax preparation software from a company like H&R Block, you’ll have confidence you’re getting every available tax deduction and minimizing your tax liability. Plus, if you have a question while preparing your taxes, they have tax advisors available to help.
Understanding the Gift Tax
Gift taxes, in all but the rarest of circumstances, are paid by the person who gives the gift. You can give any individual a gift up to the federal gift tax exclusion amount without having to file a gift tax return to report the gift. For the 2020 and 2021 tax years, the annual exclusion amount is $15,000. The exclusion applies per person, not to the total of gifts given.
For example, say you’re married, and you and your spouse have three children. You and your spouse can each give up to $15,000 per year to each of your three children. In total, you and your spouse could give away $90,000 to your kids in 2021, tax-free, and you wouldn’t have to file a gift tax return.
What if you want to give away more? Let’s say you’re not married and want to help one of your children by giving her $20,000 for a down payment on a house. Since you’re giving her more than the annual exclusion amount, you’ll have to file a gift tax return using Form 709.
If you’re married and live in a community property state, gifts of community property are deemed to be given half by you and half by your spouse, and you each will need to file Form 709 to report your half of the gift.
However, you might not have to pay tax on your gift at all, thanks to something known as the lifetime exemption.
The Lifetime Exemption
Gift givers can subtract gifts greater than the annual exclusion amount from their lifetime exemption amount without having to pay taxes on it. With the passage of the Tax Cuts and Jobs Act of 2017 (TCJA), the lifetime exemption increased significantly. For 2021, it’s $11.7 million per person. (Are you starting to see why most people don’t need to worry about gift taxes?)
If you’re generous enough to use up your lifetime exclusion, the gift tax rate you’ll pay ranges from 18% to 40%. However, there are several exceptions and special rules for calculating the tax, so check out the Instructions for Form 709 for more details on calculating your gift tax.
Keep in mind that tapping your lifetime exemption reduces the amount that can be excluded from your federal estate tax when you die. For example, if you used $2 million of your lifetime exemption before you pass away in 2021, your estate tax exclusion would be $9.7 million instead of $11.7 million. The lifetime gift exemption applies separately to the taxpayer and spouse, so the combined lifetime exemption for a couple is $23.4 million for 2021.
As long as your individual gifts are less than the annual gift tax exclusion amount, you can give to as many individuals as you like; you won’t reduce your lifetime exemption or, in turn, your estate tax exemption.
Tax Exemptions for Gifts
If you’re worried about chipping away at your lifetime exemption, there are a few circumstances in which you can provide financial assistance without declaring that assistance a gift. The Instructions for Form 709 detail these exceptions:
- Education. If you pay a friend or family member’s private school or college tuition, even if it costs more than $15,000 per year, it isn’t considered a gift, as long as you pay this tuition directly to the institution.
- Health. If you pay someone’s medical bills because that person doesn’t have health insurance, or you pay for a home health aide when someone needs assistance, it is not considered a gift as long as you directly pay the hospital or home health agency.
- Spouse. If you and your spouse maintain separate bank accounts or investment accounts, you may give each other as much money as you’d like without considering it a taxable gift. There is one catch: You must both be United States citizens. The annual limit for gifts to a spouse who is not a U.S. citizen is $157,000 in 2020 and $159,000 in 2021.
- Politics. You may donate to political organizations without paying any taxes. These are not considered charitable donations, however, so you can’t deduct them on your income tax return.
Different Forms of Gifts
When gifts take the form of stocks or real estate, the $15,000 per person limit still applies. Gift givers must base their numbers on fair market value. For example, if you give a gift of stock shares, you’d calculate the market value of your stock on the day it’s transferred. If you gift property, you must get an appraisal to determine the current value.
You should also provide the recipient with your cost basis. In the case of stock, your basis is the cost of the stock when you bought it, minus any brokerage fees, plus any dividends reinvested over the years. For property, your basis is the amount you paid for the property, plus improvements made to the property, minus depreciation if any. Your basis will become the recipient’s basis in the property, so they will need that information to calculate the gain when they sell it.
For a gift given during the donor’s lifetime, the donor’s basis is the basis for the recipient. Gifts of property received on the death of the donor get a stepped-up basis to fair market value on the date of death.
Here’s an example. Suppose you bought 100 shares of stock at $10 each. That makes your basis $1,000. Let’s assume you transfer these shares to your son when they’re worth $100 each. If your son holds them for several years, then sells them at $120 each, he will have a capital gain. Disregarding brokerage commission, his proceeds would be $120 x 100 = $12,000. His capital gain will be his proceeds minus the basis, or $12,000 – $1,000 = $11,000.
Similarly, suppose you gift your daughter a house that you purchased for $60,000 and put $20,000 in improvements into over the years. Your basis is $80,000. Your daughter turns around and sells the house for $100,000. She’ll pay capital gains taxes on a $20,000 gain.
Most people enjoy giving to their family and friends, and with the increased limits on the gift tax exclusion, it’s becoming easier for everyone. The rules are still complicated, though.
If your generosity comes close to the annual gift tax exclusion, it’s best to consult with an estate planning attorney or CPA to best determine how to transfer your wealth and maximize your tax strategy. And be sure to keep good records of all gifts and gift tax returns you file so that you can keep track of how much of your lifetime exemption you have remaining.