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Tax Guide

Gift Taxes Explained - Are They Really Tax Free?

Gift Taxes Explained - Are They Really Tax Free?
Ines Zemelman, EA
21 February 2020

Definition

The gift tax is a tax on the transfer of property by one individual to another while receiving nothing or less than full value in return.

For Example,  Father gave gifts to his daughter $600,000, for which she pays father $100,000. Then $500,000 (600,000 - 100,000) is considered a gift. Payments exceeding the legal obligation for transferring money to a given person is always a gift in the eye of the IRS, except for transferring money to a spouse.

When does the tax apply?

The Gift tax applies to transfers made while a person is living. The generation-skipping transfer tax is an additional tax on a transfer of property that skips a generation.
 

What is an exemption amount for gift tax?

The tax provides a lifetime exemption of $11.2 million per donor in 2020. This exemption is the same that applies to the estate tax and is integrated with it (i.e., gift reduce the exemption amount available for estate tax purposes). Beyond the exemption, the donor pays gift tax at the estate rate of 40%.

An additional amount each year is also disregarded for both the gift and estate taxes. This annual exclusion of $15,000 is granted separately for each recipient. Thus, a married couple with 3 children could give their children a total of $90,000 each year($15,000 from each parent to each child) without owing tax or counting toward the lifetime exemption

Gifts received are not taxable income to the recipient.

Generation-skipping trust tax

Congress enacted the GST tax in 1976 to prevent families from avoiding the estate tax for one or more generations by making gifts or bequest directly to grandchildren or great-grandchildren. The GST tax effectively imposes a second layer of tax (using the exemption and the top tax rate under the estate tax) on wealth transfers to recipients who are two or more generations younger than the donor.
 

Who is liable for paying taxes?

The gift tax is an excise tax on the right of an individual to transfer property to another. As such, the donor of the gift is liable for the gift tax, not the donee.  The gift tax is assessed only on individuals, no business entities, such as a corporation.
 

Main elements in Gift

 

  Gift tax  
  1. The donor must be competent.
  2. The donor must have the intention of making a gift.
  3. The donee must be capable of receiving and possessing the property.
  4. There must be actual or constructive delivery of the property to the donee or the donee’s representative.
  5. The donee (or the legal guardian acting on his behalf) must accept the gift.

​​​​How do the gift and generation-skipping transfer taxes work?

 

  Here’s how the gift tax works  
  • Congress enacted the gift tax in 1932 to prevent donors from avoiding the estate tax by transferring their wealth before they died.
  • The tax provides a lifetime exemption of $11.2 million per donor in 2018. This exemption is the same that applies to the estate tax and is integrated with it (i.e., gifts reduce the exemption amount available for estate tax purposes). Beyond that exemption, donors pay gift tax at the estate tax rate of 40 percent.
  • An additional amount each year is also disregarded for both the gift and estate taxes. This annual exclusion, $15,000 in 2018, is indexed for inflation in $1,000 increments and is granted separately for each recipient. Thus, a married couple with three children could give their children a total of $90,000 each year ($15,000 from each parent to each child) without owing tax or counting toward the lifetime exemption.
  • Gifts received are not taxable income to the recipient.

 
And here’s how the generation-skipping trust tax works:  
  • Congress enacted the GST tax in 1976 to prevent families from avoiding the estate tax for one or more generations by making gifts or bequests directly to grandchildren or great-grandchildren. The GST tax effectively imposes a second layer of tax (using the exemption and the top tax rate under the estate tax) on wealth transfers to recipients who are two or more generations younger than the donor.

What is the difference between carryover basis and a step-up in basis?
 

A capital gain occurs if a capital asset is sold or exchanged at a price higher than its “basis,” the original purchase price plus the cost of improvements less depreciation. When a person inherits an asset, the basis becomes the asset’s fair market value at the time of the owner’s death. This is called a “step-up in basis” because the basis of the decedent’s assets is stepped up to market value. With gifts made during the giver’s lifetime, the recipient retains the basis of the person who made the gift (“carryover basis”).

The donor’s income does not include the unrealized gain ( or loss) on assets. The recipient does not owe any tax until the assets are sold, at which point any gain is taxable. The taxable gain is the amount received from the sale of the asset less the asset’s basis. For most sales, the basis is the amount the taxpayer invested in the asset, adjusted for subsequent improvements, depreciation and certain other items. For gifts and bequests, however special basis rules apply.

For gifts, the basis remains the same as when the asset was held by the person who made the gift (“carryover basis”, but with an adjustment for any gift tax paid.

For inheritances, the basis is the FMV of the asset at the time of the donor’s death (or six months afterward, if the executor elects the alternative valuation date) This is referred to as “step-up- in basis” (or “stepped-up basis”) because the previous basis is stepped up to market value.

The effect of carryover basis on gifts is to tax unrealized gains accrued by the donor when the recipient sells the asset. The effect of step-up in basis on inheritances is to eliminate income tax on any unrealized gains accrued by the decedent.

Ines Zemelman, EA
founder of Taxes for Expats