Making generous gifts to others isn’t just about sharing your abundance with others – it’s also smart estate planning. But if you don’t follow the rules, you – or your estate – could face an expensive gift tax bill. Here’s what you need to know about gifting.
The recipient doesn’t pay tax on the gift
Gift tax is a tax on the person who gives the gift. The recipient won’t pay income tax on the value of the gift, nor will they pay gift tax. And, as we’ll see below, most donors won’t pay gift tax either.
What counts as a gift?
A gift is a transfer of value to another person with no expectation of a reciprocal exchange. Besides gifts of cash or physical items like a car, gifts can occur when someone receives more in value than the payments they make. Making a loan to another, then forgiving the unpaid balance is considered a gift. Selling a home to a relative for $300,000 when the fair market value of that home is $750,000 is another example of a gift.
The good news is there are several ways to share your wealth without making a taxable gift:
- Paying tuition or medical expenses for another person. These types of gifts must be paid directly to the educational institution or to the medical service provider.
- Gifts to a spouse
- Gifts to political organizations
- Gifts to qualifying charities
Gifts of these kinds and in any amounts are exempt from the rules for taxable gifts.
How much can I give without paying gift tax?
Every year, you can make tax-free gifts up to the annual exclusion amount. For 2021, the annual exclusion is $15,000 per person. In 2022, this will increase to $16,000 per person. The annual exclusion applies to the recipient of the gift, so you can make as many gifts at or below this amount to as many separate individuals as you desire. A married couple can combine their gifts to a single individual and double their tax-free gift to that person. For example, in 2022, a married couple could gift their adult child $32,000 without exceeding the annual exclusion.
What happens if I give more than the annual exclusion?
Gifts that exceed the annual exclusion must be reported on a gift tax return, Form 709. If you gift a single person $75,000 in 2022, you’ll have to report the additional $59,000 as a taxable gift. But that does not mean you’ll be immediately paying gift tax. All taxable gifts you make are credited against a lifetime exemption for the total amount you can gift without paying gift tax.
For 2021, the lifetime exemption is $11.7 million, and in 2022, the exemption amount moves to $12.06 million. It’s not until your lifetime taxable gifts exceed the lifetime exemption that you will need to pay gift tax. Using the above example, if the taxable gift of $59,000 is your first taxable gift, you can still make taxable gifts of up to $12,001,000 over your lifetime.
The unified credit system for gift and estate taxes
The lifetime exemption for gift taxes is part of a unified credit system for tax-free transfers of wealth before any gift or estate taxes apply. Any taxable gifts made during your lifetime reduce the exemption from estate taxes at your death. For example, a person who gifts $5 million during their lifetime will use up $5 million of the estate tax exclusion. If that person passes away in 2022, any assets that exceed the remaining $7.06 million ($12.06 – $5) of the estate tax exemption will be subject to estate tax.
The linkage of the gift tax and estate tax exclusions means that a key to preserving as much of your estate tax exemption as possible will be a gifting strategy that minimizes taxable gifts during your lifetime. It also means that a key to minimizing estate taxes – which can be levied at a rate of up to 40% – is reducing your estate as much as possible during your lifetime by maximizing tax-free transfers of wealth.