GIFTS AND TAXES
A very common question that we frequently receive from clients is “If I want to make a cash gift to my kids, do I have to pay gift taxes?” The answer to that question depends on number of items such as:
The amount of the gift
Your lifetime exclusion limit
What state you live in
However, there are other things to consider beyond just these items that I'm going to cover in this article such as:
How gifts are taxed
The annual gifting limit
Your lifetime gifting limit
Cash vs Non-cash gifts (cars, houses, stock)
Tax forms that need to be submitted to the IRS
Advanced gifting strategies
Beware the cost basis pitfall when gifting
The Annual Gift Limits
Each year The IRS sets a limit on the amount that you can gift to any one person without it counting towards your lifetime exclusion amount. In 2021, the annual gifting limit is $15,000 but that amount can change from year to year. Many people assume that as long as their gifts are below that dollar threshold that no gift tax has to be paid but if they gift over that annual limit then someone has to pay gift tax. For most individual, that is not the case due to the lifetime exclusion limits.
Lifetime Gifting Limits
There is something in the federal tax law called the lifetime estate and gifting exclusion. This is the dollar limit that you are allowed to either gift away during your lifetime or that you are able to pass onto your heir after you die without having to pay federal income tax. The limits in 2021 are very high. Each individual has a $11.7 million lifetime exemption ($23.4M combined for married couples) before anyone would owe federal tax on a gift or inheritance.
In other words, you could gift your son or daughter $10 million dollars today, and no one would owe any federal gift tax on that amount. So wait……..then what’s the deal with the $15,000 annual gift limit? Each year you are allowed to gift away $15,000 to ANY NUMBER OF PEOPLE and it will not count AGAINST your $11.58M lifetime exclusion allowance.
Example: You have 5 children and you gift each of them $15,000. Since you did not exceed the $15,000 annual limit to any one person, no one owes any federal tax on the gift, and you still have your full $11.58M lifetime exclusion amount.
If instead, you made a $100,000 gift to one child, that’s $85,000 over the $15,000 annul limit, your $11.58M lifetime exclusion amount is reduced by $85,000 so you only have $11.49M left.
As you can see, gift tax is only an issue for individuals that plan to gift very large amounts over their lifetime or will have big estates when they pass away because the gift and estate exclusion is an aggregate amounts. This is why it would be a major benefit to have a trust in place.
Filing A Gift Tax Return
If you keep your gifts below $15,000 per year to any one person, it’s not a taxable event, and there is nothing that you need to file with your tax return. If however, you decide to make a gift to someone above the $15,000 per year annual limit, no one will owe any federal gift tax, but you will have to file a gift tax return with your personal tax return which provides the IRS with the amount that you gifted over the annual gift exclusion limit. This is how the IRS tracks how much of your lifetime exclusion you have used.
You also have to be aware of your state gifting laws because they can vary from the federal limits. While many states have annual gift exclusions and lifetime exclusion limits similar to the IRS, the limits can vary.
For example, in New York for 2021, the lifetime estate and gifting limit for an individual is $5.93 million. Still a large amount but only half of the federal limit. If you gift someone $8M, you may not own federal tax but you could owe state taxes. When you get to these higher gifting thresholds you also have to be aware of generation skipping tax (GST) depending on who the recipient is of the gift.
Gifting Limits Subject To Change In The Future
Be aware that these limits have changed in the pasts and they will most likely change at some point in the future. Given the size of our federal and state government deficits, at some point these government entities may need to make changes to the tax laws to generate more income for the government to repay the debt. For example, they could reduce the federal lifetime exemption from $11.5M to $1M per person which would generate more income for the government when people pass away or make large gifts.
There are two lessons here. First, don't be wasteful with your lifetime exemption amount because the limits could be reduced in the future and you may need it to avoid taxes when your assets past your heirs. Second, if you have a large estate, now is the time to be consider making large gifts while the federal lifetime limits are still at historically higher levels so those gifts are hopefully grandfathered in under the current tax laws.
Advanced Gifting Strategies
Some clients have a desire to give large amounts but do not want to eat into their lifetime a estate and gift exclusion allowance. Promissory notes can sometimes be used to execute these advanced gifting strategies.
For example, your daughter is starting a business, and you would like to gift her $200,000 to help get the business off the ground. Instead of gifting her $200,000 in a single year eating up $185,000 of your lifetime exclusion, you could structure the gift as a loan. You draft a promissory note for the $200,000 loan, can you make the loan duration such that the annual loan payments are below $15,000 per year. You issue her a $200,000 check for the loan which is no longer considered a gift and then each year you gift her $15,000 to basically make the loan payments back to you. If you are married, you can gift her $30,000 per year to make loan payments, $15,000 from you and $15,000 from your wife. You would then write into your will that if you pass away before the loan is paid in full that they loan is forgiven.
Cost Basis Pitfall
The annual and lifetime gifting limits exist whether you are gifting someone cash or a non-cash items like a car or a house but you have to be aware of the cost basis pitfalls associated with gifting non-cash assets. When you make a gift to someone, the amount of the gift is based on the fair market value of that asset when the gift is made, however the person receiving the gift inherits your cost basis in that asset. Versus, if they inherit the assets from you, they receive a step-up in basis.
Let me explain this via an example. The most common example that we see is parents gifting their house to their kids while they're still alive. Assume the parents bought the house 30 years ago for $50,000 and now the house is worth $300,000. If they give the house to their kids today, they have made a $300,000 gift in a single year, it does not trigger a tax event because it's still below their lifetime exclusion, but the kids inherit their cost basis of $50,000. Meaning, when they pass away and the kids sell the house, assuming the house sells for $300,000, they would have to pay tax on the $250,000 gain.
Instead, if the parents retained ownership of the house, when the parents pass away, their kids would receive a “step-up in basis” meaning their cost basis in the house is the value of the house as of the date of death. If they sell the house for $300,000 and their cost basis in the house is now stepped up to $300,000, they would not owe any tax saving thousand of dollars in taxes that would have been paid under the gifting scenario.
Lesson: When gifting non-cash assets that have appreciated in value, make sure you're aware of the tax impact. A little advantage tax strategy, if you have a desire to gift money to a charity or not-for-profit, sometimes it makes sense to do so with assets that have appreciated in value because when they sell them they don't have to pay taxes given their not-for-profit status. Be sure to consult wit your tax advisor when executing these advanced gifting strategies.