Gifts are built into many of life’s traditions and are a thoughtful way to exchange items with loved ones and friends. Interestingly, when it comes to high-value gifts there are a few financial considerations to keep in mind. Most notably is the answer to, “Are gifts taxable?”
Gifts are taxable -- but it will require a lot of giving before the IRS takes notice. It is still important to understand how gifts are treated legally and what the overall gift limits are. There are certain tax forms to be aware of, as well as lifetime exclusion amounts that could one day impact your Estate Planning. Keep reading to learn exactly how the gift tax works and more:
What Is Gift Tax?
The gift tax is a federal tax levied by the Internal Revenue Service (IRS) on the transfer of money, assets, or property where the recipient exchanges nothing in return. The definition of a “gift” in the eyes of the IRS also includes interest-free loans, regularly generated income without services, and even items sold at less than the actual value.
This tax was first enacted in the early 1900’s as a way to prevent wealthy families from a practice called income shifting. Essentially, wealthy individuals would “gift” away their money to younger generations as a way to avoid income and Estate taxes. The purpose of the early gift tax regulations was to prevent this from happening.
Although this tax is well-regulated, many individuals are still able to avoid the gift tax completely despite giving and receiving presents throughout their lifetimes. The reason for this is because of the annual gift tax exclusion, which allows for gifts below a certain amount to exchange hands without incurring taxes. As of 2021, the gift tax exclusion is set at $15,000 per recipient.
What Qualifies as Gift Tax?
Anything that is given without fair payment qualifies as a gift for tax purposes, with few exceptions. Gifts can include money, real estate, items, or any other type of assets. The exclusions are generally for money that is donated to charity, educational costs, or medical expenses. Here are just a few examples of gifts that would count towards the gift tax:
Assets sold for less than the fair market value
Interest free loans
Houses, cars, other property
Note that it does not matter how the donor or recipient are related when determining the gift tax, unless the gift is being exchanged between two spouses. Married couples can exchange gifts, money, etc. without worrying about annual limits. However, gifts between parents, adult children, siblings, friends, and more all qualify for the same gift tax rules.
Who Pays the Gift Tax?
The gift tax is traditionally paid for by the donor. There are certain cases where the recipient can agree to pay the taxes, though these situations are much less common. It is also the donor who will be responsible for filing a gift tax return; in most instances, recipients are not required to report gifts.
How Much is Gift Tax?
The gift tax rate is between 18 and 40 percent, depending on the value of the gifts. Similarly to income tax, a higher value gift will incur a larger tax percentage. For example, a gift of up to $10,000 above the annual gift tax limit will be taxed at a rate of 18 percent. A gift that is more than $1 million above the limit, will be taxed at a 40 percent rate.
How Much is the Annual Gift Tax for 2021-22?
For 2021-22, the annual gift tax limit is $15,000 per recipient. This means that a donor can give up to that amount to as many individuals as they want, without being responsible for the gift tax. The annual limit is raised periodically to account for inflation.
What is the Lifetime Gift Tax Exclusion?
Aside from the annual gift tax limit, there is also a lifetime exclusion to be aware of. The current lifetime gift tax exclusion is $11.7 million. The lifetime limit is used anytime a donor exceeds the annual gift limit. Once this happens, the donor becomes responsible for the corresponding tax rate which is then deducted from their lifetime tax exclusion.
Many individuals do not exceed the lifetime gift tax exclusion, and consequently can avoid ever paying gift taxes. However, the lifetime exclusion is also used when settling an Estate. At that point, any Estate taxes would also count towards the $11.7 million exclusion. If you gave away generous gifts in your lifetime and had a high-value Estate at the time of your death, your Estate could be subject to additional taxes.
Gift Tax Examples
Let’s look at a hypothetical example to better illustrate how the gift tax works. After playing her investments right, Maya notices she has a significant amount of disposable funds she wants to give away. Maya decides to buy her younger brother a car, totaling $10,000 in value. She then gives her brother a $10,000 check for his birthday in the same year. Maya also decides to give her brother’s spouse a new phone and spends around $1,500.
In this example, Maya has exceeded the annual gift tax limit by giving her brother a new car and birthday check with a combined value of $20,000. Maya will need to file a gift tax return for $5,000, which is the amount exceeding the annual gift limit. The money spent on the phone will not count towards this limit because spouses are treated separately for gift tax purposes. After the gift tax return is filed, Maya will most likely be responsible for an 18 percent tax (roughly $900). This amount will then be deducted from her lifetime gift tax exclusion.
How to File a Gift Tax Return
A gift tax return -- called Form 709 -- is required when you give one or more recipients gifts totaling over $15,000 each in one tax year. The steps to file a gift tax return are relatively simple, though when in doubt consult your tax planning attorney or financial advisor.
The form is required along with your other tax return documents before April 15, the year after the gift is made. You can apply for an extension which, once approved, will extend the gift tax return deadline to October 15.
Gift tax returns are also recommended when you transfer assets that are hard to appraise within a tax year, such as rare items or shares in a family business. The purpose of disclosing these gifts is to protect you from the IRS, should they challenge your valuation.
Form 709 will include instructions on how to calculate the amount owed. Remember that just because you submit a gift tax return does not mean you will actually be responsible for paying additional taxes. Again, this is where the lifetime exclusion amount comes into play.
Consider Specifying Gifts in Your Estate Plan
Gifts can include any number of items given away on different occasions, but the IRS is most interested in high-value presents. The purpose of the gift tax, annual limit, and lifetime exclusion are all to reduce various tax avoidance methods.
That being said, there are still ways to approach gift giving and Estate Planning with a tax-forward strategy in mind. A few ways to do this are by following the various gift tax limits, spreading out your spending, and even by leveraging an Estate Plan.
By creating an Estate Plan, you can designate specific gifts to your loved ones. Further, you can take advantage of several financial planning strategies during your lifetime, such as creating a Trust, to help avoid incurring excess taxes. Reach out to our team today if you are interested in learning more about this process.
Have you ever asked the question, “are gifts taxable?” The answer is somewhat complicated, as most tax-related answers are. The IRS may not be interested in your graduation cards, but they will take notice of large sums of money or property you receive. Review the above information on the gift tax and its various limits so you can take a stronger approach to your finances. When you are ready to get started, you can use this information to bolster your Estate Plan.
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