The Rules Of The IRS Gift Tax
Complicated -- that's how the Internal Revenue Service describes the tax code regulating the gift tax. It is often misunderstood because this particular tax burden falls on the person doing the giving, not the person who receives the gift.
The gift tax was created so that taxpayers wouldn't give away all of their wealth while they were alive as a way to avoid estate taxes after they were gone.
Before you panic, the IRS says that most gifts you'll give, for whatever reason, will not be subject to the gift tax. Those that are taxed, however, can be heavily taxed.
What's A Gift?
The IRS considers something a gift if you give it away forever and the recipient doesn't give you anything of equivalent value in return. Cash, securities, real estate and jewelry are all examples of things that can be gifted.
Also, if you sell something for less than its fair market value, it can be considered a gift by the IRS. The same is true for an interest-free or reduced-interest loan you make to someone.
How Much To Give?
The IRS allows an annual gift tax exclusion of $13,000. That means each calendar year you are allowed to give another person $13,000 worth of gifts without paying any extra taxes. There is no limit to the number of individuals you can gift to. If you and your spouse are gifting together, you can make that $26,000 to each individual. The amount of the gifts given beyond those exclusions can be subject to a tax rate between 18 and 35 percent.
There is however, a lifetime gift ceiling. The tax code for 2011 says you can give away $5 million in cash or items during the course of your life before the excess will be subject to the gift tax. That tax rate is 35 percent in 2011.
Your tax liability on gift amounts above your annual exclusion or your lifetime ceiling can be reduced by using the unified credit. It's called unified because it is one amount that can be applied against gift or estate taxes. For 2011, the unified credit was $1,730,000 per taxpayer in their lifetime. Subtracting taxes owed from the credit reduces the amount of the credit available to you in later years. The IRS changes the unified credit amount annually.
Give As Much As You Like Tax Free In These Situations
There are some gifts that don't count against your annual or lifetime ceilings. You can give as much as you want to your spouse, if he or she is a U.S. citizen.
You're also allowed to give unlimited gifts to charitable organizations or political organizations that are recognized by the IRS.
You can pay someone else's medical bills as a gift, as long as the payments are made directly to a health care provider.
You can also cover someone's tuition, as long as those payments are made directly to the educational institution.
So why should you give your wealth away while you're still alive?
Your heirs can thank you in person and you'll be able to see what they are doing with their inheritance.
From a tax perspective, you have removed that asset from what your eventual estate will be worth. Gifting is a strategy for reducing exposure to the estate tax by keeping the value of the estate lower.
But giving away assets also reduces how much money you have as you age. And no one knows how many years or how expensive the rest of your life will be.
Is A Gift Taxable Income?
If you are on the receiving end of a gift, you don't have to report it as income or pay any income taxes on it. Gift taxes are paid by the giver.
Report Your Gifts
If you are giving gifts that exceed the annual exclusion, or you and your spouse have decided to combine your exclusions or you have surpassed your lifetime gift ceiling of $5 million, you will need to report any additional gifts you are giving each year to the IRS using Form 709.
Using Gifts In Estate Planning
Giving away assets can be one part of prudent estate planning. However, the IRS is very clear about how complex the gift and estate tax codes are. Therefore, it encourages taxpayers to seek professional help with these issues. The agency suggests seeking the advice of an attorney, a CPA or both. And it emphasizes that those professionals should have "considerable" experience working in the areas of gifts, estates and wills.
Knowing the basics of how gifts are taxed can help you and your family members make prudent financial decisions. Remember that the gift and estate tax codes changes frequently, so what you know this year might not hold true for the next. Therefore, you might want to get professional advice to help keep you up to date.