The following provides an overview of the federal gift tax and the related income tax implications when gifts are made. This area of the law has taken on greater importance as the IRS has now begun an aggressive campaign in auditing taxpayers for gifts of real estate interests. The IRS is actually reviewing recorded deeds to discover unreported gifts of real estate interests.
The irony here is that very often a gift of real estate to a loved one is not a good idea from an income tax perspective. Unknowingly taxpayer transfer, and real estate agents and even real estate attorneys recommend gifting real estate without understanding the gift and income tax implications. The point is that before making any gift, it should be discussed with your tax attorney or tax accountant to see if it really makes practical, financial and tax sense in your particular situation.
Many gifts are not subject to the gift tax. For example, there is usually no tax if you make a gift to your spouse or to a charity. If you make a gift to someone else, the gift tax usually does not apply until the value of the gifts you give that person (the donee) exceeds the annual donee exclusion for the year and the donor’s remaining lifetime gift tax exemption. For 2010 and also in 2011, the annual donee exclusion is $13,000 and the lifetime gift tax exemption is $5 million. Both of these will be discussed in more detail below.
Gift tax returns do not need to be filed unless you give someone, other than your spouse, money or property worth more than the annual donee exclusion for that year. Note, that the for the gift to qualify for the annual donee exclusion, it must be a present interest gift. This is a defined tax law term but basically the donee must have the present enjoyment and possession of the gift for it to qualify for the annual donee exclusion.
Gifts of greater than $13,000 are subject to gift taxes when the person has given during their lifetime more than the lifetime gift tax exemption. In 2011 and 2012, the lifetime gift tax exemption is $5 million. So a person can give up to $5 million during their lifetime, in addition to any annual donee exclusion gifts they have made, before being subject to any gift taxes.
Note that recent tax law changes have unified the gift and estate tax credit. So if a person uses up some or even all of their lifetime $5 million gift tax exemption, the amount used during their lifetime it is not available to reduce estate taxes at their death. A gift giving program using the annual donee exclusion and the lifetime gift tax exclusion can result in significant overall tax savings to a family. However, you should consult with an estate or tax attorney before engaging in any tax planning strategies in this area. Please read our related article Gift Giving: Tax Advantages.
Generally, the person who receives a gift will not have to pay a federal gift tax on receipt of such gift. Also, that person will not have to pay income tax on the value of the gift received. However, there are exceptions to this rule. For example, if the gift is of a retirement benefit, an annuity or other forms of income called “income in respect of a decedent,” the recipient will pay income taxes on these type of gifts or bequests.
Making a gift does not ordinarily affect the federal income tax of the maker (donor) or the recipient (donee). You as the donor cannot deduct the value of gifts you make to individuals. Remember however, you can deduct on Schedule A as an itemized charitable deduction gifts that you make that qualify as charitable contributions to tax exempt qualified charitable organizations. Remember that there are various adjusted gross income limitations on such gifts that vary depending on the type of charity and the type of assets gifted to such charity.
The following gifts are not subject to gift tax:
(A) Gifts that are not more than the annual exclusion for the calendar year. The annual exclusion is $13,000 per donee per year for 2011.
(B) Tuition or medical expenses you pay directly to a medical or educational institution for someone. Certain rules apply and the amount can be unlimited if certain tests are met.
(C) Gifts to your spouse. This amount is unlimited.
(D) Gifts to a political organization for its use; and
(E) Gifts to charities. Such charitable gifts can generate income, gift or estate tax deductions. The exploration of the use of charitable remainder trusts are beyond the scope of this article.
You must file a gift tax return on Form 709, if any of the following apply:
(A) You gave gifts to at least one person (other than your spouse) that are more than the annual exclusion for the year
(B) You and your spouse are splitting a gift
(C) You gave someone (other than your spouse) a gift of a future interest that he or she cannot actually possess, enjoy, or receive income from until some time in the future
(D) You gave your spouse an interest in property that will terminate due to a future event.
This strategy will allow you to double the annual donee exclusion. By having a spouse join in a gift, you can make a tax free gift of up to $26,000 to as many donees as you wish each and every year. The gift can be considered as made one-half by you and one-half by your spouse. If you split a gift you made, you must file a gift tax return to show that you and your spouse agree to use gift splitting. You must file a Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, to take advantage of this gift splitting election even if half of the split gift is less than the $13,000 annual donee exclusion.
Example: If Richard Rich and his wife have three children and 4 grandchildren, they could give $26,000 to each of these seven donees. This would remove $182,000 in one year from their taxable estate. Since this donee exclusion is available each year, this gifting program could be repeated year after year. Importantly, note that this is done while not having to use up any of the $5 million unified gift tax credits of for each spouse. If this annual gift giving strategy is repeated for a couple years, it can be a very powerful tool to reduce a family’s ultimate estate taxes. However, this example speaks only to tax savings but there may be practical, financial, family and other factors to consider before employing this strategy.
You do not have to file a gift tax return to report gifts to political organizations and gifts made by paying someone’s tuition or medical expenses.
The above is only an overview of the general rules in this area. In the right situation, gift giving strategies can generate a significant amount of tax savings to a family.
However, where highly appreciated property or where real estate is concerned, making gifts to family members can be the wrong move. One fundamental reason is that when lifetime gifts are made the recipient takes a “carryover” basis in the property. Basically, carryover basis is what the maker of the gift (donor) paid for the property plus improvements. If property is transferred at death, then the donee gets what is called a “step-up” in basis to the fair market value at the date of death. So if the property was purchased a long time ago by the owner who makes a gift of such property, the donee may have a very low basis in the property. As a result, large capital gains taxes can be incurred when the real estate is sold by the donee. Waiting and having the real estate pass at the date of death would eliminate the capital gain tax entirely.
The upshot of all this is that any transfers of real estate or highly appreciated property should be discussed with your tax attorney before a large tax mistake is made. Sometimes lifetime gifts make sense and other times they can have really bad tax results. It all depends on each taxpayer’s particular situation. Anyway, feel free to contact our office to discuss these issues in more detail and before making a costly error in this area.
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