How Does the Gift Tax Work?

The gift tax. Perhaps you’ve heard the term, but do you know what it means? Many people don’t, so I thought I’d spend a bit of time talking about it.

What is a gift?

For starters, the IRS defines a gift as “any transfer to an individual, either directly or indirectly, where full consideration (measured in money or money’s worth) is not received in return.”

In other words, if you give someone something of value and don’t receive an equal value in return, you’ve given them a gift. Pretty simple, right?

Tax treatment of gifts

Gifts that you receive are not considered income, and you don’t report them on your tax return no matter how large they are. That being said, you can’t simply dodge taxes by calling your income a gift. If, for example, you receive a “gift” in return for services rendered, it’s not a gift.

So what’s all this talk about gift taxes? Well… The gift tax actually applies to the donor, not the recipient. The whole point of this tax is to prevent individuals from transfer their estate to others before their death, thereby avoiding the estate tax.

Exclusions from the gift tax

Before we go any further, it’s important to recognize that there are several categories of gifts that are not subject to the gift tax. These include charitable contributions, gifts to a spouse, gifts to a political organization, and tuition or medical payments made on behalf of someone else.

In addition to the above, there is an annual gift tax exclusion that currently stands at $13k/recipient. In other words, you’re allowed to give away up to $13k worth of gifts per recipient to as many recipients as you wish in a given year without any tax ramifications. Note that this limit is effectively doubled for married couples, who can jointly give gifts up to $26k/year total to a single recipient.

There is also a second, $1M lifetime limit of gifts in excess of the $13k annual limit before the gift tax is triggered. If you exceed this limit, then you’ll either have to pay the gift taxes that year, or use up a portion of the “unified credit” that would otherwise be used to offset the estate tax upon your death.

Gift tax returns and the gift tax rate

If you exceed the annual exclusion of $13k/recipient, you’ll have to file a gift tax return. But don’t worry… You still won’t have to pay the gift tax until you burn through that $1M lifetime limit.

So what happens once you exceed your $1M lifetime limit? How much will you owe? Given that the whole point of the gift tax is to stop you from avoiding the estate tax, it shouldn’t be a surprise that the gift tax rate mirrors that of the estate tax.

In 2009, the estate tax topped out at 45%. As I’ve noted previously, there’s no estate tax in 2010, but it will come back with a vengeance in 2011, with a top rate of 55%. This is significantly higher than the top income tax bracket, so we’re talking about some fairly serious taxes.

Gift tax vs. estate tax

Despite the overall similarity between the gift tax and the estate tax in terms of the tax rate, there are some important differences in the tax treatment of gifted assets vs. those that are transferred as part of an estate.

Notably, if the gift is anything other than cash, then its cost basis transfers to the recipient, unless the value on the date of transfer is lower than at purchase, in which case they should use the lower value. In contrast, if the property is transferred as part of your estate, then the cost basis steps up to the value on the day you die.

The key difference here is that a gifted asset carries a higher future tax liability than one that transfers upon death. In other words, if the recipient were to turn around and sell it at some point in the future, a gifted asset will typically have a larger gain than an inherited asset.

Whew. So there you have it. The gift tax in a nutshell.