One common mistake I often see is people giving money to somebody without understanding the tax consequences of doing so. For example, when a friend of mine gives his girlfriend $3,000 a month to cover some living expenses and pay off some debt, he is making a gift that exceeds the annual exclusion amount and it needs to be reported to the IRS. The same applies to parents helping their children with a down payment on a home – the money given is considered a gift that exceeds that annual gift exclusion and must be reported to the IRS. Another example is loaning money to relatives without charging interest; this is also a gift and can be subject to gift tax.
In this post, I’d like to talk about important concepts and rules of gifting to help you avoid mistakes, taxes, and penalties.
First, let’s define a gift. A gift is a voluntary transfer of property from one person (the donor) to another person or entity (the donee) for less than fair market value. The donor must be competent to make the gift, and the donee must be capable of receiving the gift. For the gift to be complete, the donor must also transfer the control over the asset to the donee.
Types of Charitable Gifts
Direct gifts are direct payment of cash or transfer of property from one person to another. For example, transferring $10,000 to your friend without expecting anything of equal value in return is a direct gift.
Indirect gifts involve transfers made on behalf of a donor for the benefit of a donee. Some examples include paying off someone’s debt, titling property in joint tenancy, providing below-market or interest-free loans, or forgiving a loan. Indirect gifts usually happen within families.
A complete gift is when the donor has released control over the asset to a donee who can be identified.
An incomplete gift is when the donor hasn’t relinquished control over the asset. As such, incomplete gifts are not taxable. A good example of an incomplete gift is a joint bank account or a revocable trust.
Reversionary interest is a gift that reverts back to the donor after a certain period. For example, transferring property for someone’s use for five years after which it reverts back to the donor.
Net gifts are gifts made on the condition that the donee pays the gifts tax. This type of gift is usually utilized when a donor has fully depleted their lifetime gift exemption.
Exclusions & Exemptions
Before making a charitable gift, it’s important to know the current annual exclusion and lifetime gift exemption amounts.
In 2024, individuals can gift up to $18,000 to any person per year without reporting gift taxes. This annual exclusion is indexed for inflation, so it usually increases each year. To qualify for the annual exclusion, the gift must be of a present interest meaning the donee can immediately use, possess, or enjoy the property without restrictions. Future interest gifts do not qualify for the annual exclusion. Another important thing to know is that the annual exclusion is available only for the current year and doesn’t carry over to future years. In other words, if you don’t use it this year – you lose it forever.
In addition to the annual exclusion, there is also a lifetime gift exemption in the amount of $13.61 million in 2024, available to each U.S. citizen and it only offsets estate tax.
Taxable Gifts
As you can see, only gifts that you make in excess of the annual exclusion amount ($18,000 in 2024), are potentially subject to gift tax. However, if you haven’t exhausted your lifetime gift exemption, there is no need to worry about paying the gift tax.
For instance, assume that you make a $25,000 gift in 2024 to your child, $18,000 is excluded from the gift tax, and only $7,000 is subject to it. Although the gift needs to be reported, no actual tax liability arises from this gift until you fully utilize the lifetime exemption.
If you are married, then you and your spouse each can gift $18,000 per donee without incurring any gift tax.
Gift-Splitting
Another important concept you need to know about is gift-splitting. Gift-splitting is available only to married couples and can double the annual exclusion per donee. Let’s say that you want to gift $30,000 to your sibling and your spouse doesn’t want to. In this case, $18,000 of the gift will be excluded from gift tax and $12,000 will be subject to it. Again, if you haven’t fully utilized your lifetime gift exemption, you won’t have to pay tax on this $12,000 gift but it will count towards the lifetime gift exemption and will reduce your future limit. What you can do instead is to split your gift with your spouse and use your spouse’s annual exclusion amount and avoid paying tax on the $12,000 amount the exceeds the annual gift exclusion limit.
Nontaxable Gifts
The good news is that not all gifts are taxable. Besides gifts under the annual exclusion amount, there are 3 types of gifts that result in no gift tax:
Marital gifts. Thanks to the unlimited marital deduction, US spouses can transfer assets between each other tax-free. Non-US spouses have a limit of $185,000 in 2024.
Qualified gifts. Payments that you make directly to a qualified educational institution for tuition or to a medical care provider for qualifying medical expenses for the benefit of the donee are not subject to gift tax and there is no limitation on the amount of qualified transfer. Just remember to make the payment directly to the institution and not the donee.
Charitable gifts. Gifts you make to 501(c)(3) organizations, federal, state, and local government for public use, and to 501(c) fraternal or veterans organizations are exempt from gift tax.
Reporting Your Gift
If you made a taxable gift, how do you report it? I talked to an IRS agent recently and asked him how does the IRS know if a person made a gift? The agent said that they don’t but they can easily find that out during an audit. Many people think they won’t be audited because their tax situation is “simple” and don’t file a Gift Tax Return. I highly recommend against this logic.
If you made a gift exceeding the annual exclusion amount or split a gift with your spouse (even if the gift is under the annual exclusions and you leave in common law state), you and your spouse must file a separate Form 709. Form 709 must be filed by April 15 of the following year but can be extended through October 15. Although the donor is generally responsible for paying the gift tax, the IRS can come after the donee if the donor can’t pay the tax.
The biggest benefit of filing Form 709 is starting the statute of limitations, which is generally 3 years from the filing date.
Without properly disclosing the gift on Form 709, there is no statute of limitations, meaning the IRS can investigate as far back as needed and even come after your heirs.
A final tip is to work with a CPA. While Form 709 may seem easy to fill out, in fact it is not, and you can easily make a mistake and report a gift in the incorrect section. Leave this work to your CPA instead.
Conclusion
Making gifts during your lifetime can be a powerful estate planning strategy with both non-tax and tax benefits. By making gifts, you can remove future asset appreciation from your estate and maintain the privacy of a transaction, all at a fraction of the cost. However, you need to know the rules and concepts to make informed decisions that will align with your financial and estate goals.
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