Despite paying taxes your entire life, even when you die, the government still wants something from you! As a financially savvy individual, it behooves you to understand as much about the tax rules as possible. After all, tax is likely your largest ongoing expense.
The Internal Revenue Code imposes a gift tax on property or cash you give to any one person, but only if the value of the gift exceeds a certain threshold called the annual gift tax exclusion. For 2020, that annual gift tax exclusion amount is $15,000.
That’s right, you’re not allowed to give more than the annual gift tax exclusion without incurring a tax. This is despite having already paid taxes on the $15,000!
For example, let’s say you earn $200,000 a year and pay a 20% effective tax rate. Your take home pay is $160,000 and you save 20% a year, or $32,000 a year.
If you wanted to give 100% of your hard-earned savings to someone, you may have to eventually pay an additional tax on $32,000 – $15,000 = $17,000 if your estate ends up over the estate tax exemption amount. Thankfully, the estate tax exemption amount is $11,580,000 per person.
Estate Tax Exemption vs. Annual Gift Tax Exclusion
Please don’t confuse the estate tax exemption amount and the annual gift tax exclusion amount. The estate tax exemption amount is the amount of wealth you are able to pass on to another person upon your death without incurring additional taxes. The top estate tax rate is 40%.
The annual gift tax exclusion amount is what you can give annually that legally reduces the size of your estate so you don’t have to pay estate taxes or so you can pay less in estate taxes.
If your estate is greater than or will be greater than the estate tax exemption amount the year you die, you strategically want to annually gift the maximum tax exclusion amount to as many people you care about as possible. Otherwise, your estate would have to pay federal estate tax on every $1 over the estate tax limit when you die. Then there are potentially state estate taxes you have to pay.
Below is a chart that highlights the federal estate tax rates. If your estate is exactly $1 million over the estate tax exemption amount, your estate will have to pay $345,800 in estate taxes. Every dollar over $1 million above the estate tax exemption amount pays a 40% federal estate tax. Ouch!
If there was no annual gift tax exclusion amount, a generous wealthy person could simply give away as much as possible up to the estate tax exemption threshold until no death tax liability remains.
Given we have already paid taxes on our wealth, I don’t think there should be an additional death tax. However, I do understand that part of the reasoning behind creating an estate tax threshold is to prevent the formation of family dynasties who could end up ruling the country just because they are rich and not because they did anything meaningful.
If you’re super wealthy, don’t worry though. You can always create, among other things, a Grantor Retained Annuity Trust, to pass on much of your fortune tax-free to your heirs.
Historical Annual Gift Tax Exclusion Amounts
The annual gift tax exclusion was indexed for inflation as part of the Tax Relief Act of 1997. Below is a chart that highlights the historical annual gift tax exclusion amounts.
The historical gift tax exclusion amount has historically gone up by $1,000 every 3-5 years. Therefore, it is likely that the annual gift tax exclusion amount by 2022 will be $16,000.
The historical gift tax exclusion amount is not huge, but it’s better than a kick in the shins. Anybody who is projected to have an estate larger than the estate tax exemption amount should seriously consider actively giving away more of your wealth to your children and loved ones today.
What Is The Definition Of A Gift?
The IRS defines a “gift” as anything for which you don’t receive full consideration in return. Sounds a little vague right? Let’s use a couple examples to illustrate.
Gifting A Property
If you sell your panoramic ocean view home in San Francisco to your nephew for only $1,000,000 when its fair market value is $3,000,000, you’ve given a gift of $2,000,000. But here’s the thing. “Fair market value” is subjective.
Some people hate San Francisco and would never in a million years pay $3,000,000, let alone $1,000,000 for a home. I’ve got the occasional reader from Georgia hating on anything I write about technology and this fine city. These folks are partially the reason why I’m investing in the heartland of America. I want to participate in the growth of lower cost, higher cap rate cities as the work from home trend explodes.
Some of you may be asking why on Earth would you sell your property to your nephew at a $2,000,000 discount to fair market value? Simple. Your estate is already well above the estate tax exemption limit. Instead of paying federal estate tax on the $2,000,000 gift, which equals at least $745,800, you’d rather find a way to gift some of the property’s value to your nephew, who is nowhere near the estate tax threshold.
Your nephew could argue to the IRS that in his opinion, he bought the property at fair market value because San Francisco is a wasteland that is way past its prime. Even if the nephew did have to pay tax on the gift, the tax rate would more than likely be lower than the estate tax rate.
Let’s say that instead of selling a property at a discount, you’re a dad who wants to make a cash gift to your son so he can purchase his own home. The last thing you want is for your 23-year-old son to live with you for years after college! My neighbor’s son moved back in at age 24 back in 2014 and he has never left.
To prevent your son from becoming totally dependent on you in adulthood, you gift your son $300,000 strictly for a down payment on a home. $15,000 of that gift is free and clear of the federal gift tax, thanks to the annual exclusion. The remaining $285,000 is a taxable gift and would be applied against your lifetime exemption if you choose not to pay the tax in the year you made the gift.
But if you strategically break up the $300,000 and gift your son $15,000 on Dec. 31, and then gift your son an additional $285,000 on Jan. 1, the December gift is free and clear and only $270,000 of the subsequent $285,000 counts against his lifetime exclusion—$285,000 less that year’s annual $15,000 exclusion. Remember, the annual gift exemption is per person per year.
You can give the annual exclusion amount to any one person every single year and never dip into your lifetime exemption. If you don’t want to pay the gift tax on the $270,000 in the year the gift is made, you can reduce your lifetime gift tax exemption by this amount. Despite your significant gift, you would still have $11,310,000 ($11,580,000 – $270,000) of the unified tax credit left to shelter your estate.
Gifting A Car
In another example, let’s say you want to celebrate your niece getting into USC with a 2.6 GPA and a 1,560 SAT score (wink, wink). You can sell her your fair market value $80,000 Range Rover Sport for just $10,000 so she can better fit in and match all her classmates’ cars. You’ve now given her a gift of $70,000. Further, you she gets to pay a much lower sales tax.
Or maybe not! When I mentioned in the past how I wanted to upgrade to a Range Rover Sport from a Honda Fit to better protect my family, I received a parade of dissenters who poo-pooed the Range Rover as one of the worst vehicles on the market due to reliability issues. To these folks, they probably wouldn’t even spend $10,000 on a new Range Rover even if their uncle wanted to sell them one! Totally fair.
Here is the IRS’s official definition of Fair Market Value: “The price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.”
In other words, estimating the actual gift amount is a gray area. Nobody forced your niece to spend $10,000 on the Range Rover. To her, it could be just another car to get from point A to point B. And for the sake of reducing everyone’s potential tax bill, she could be right.
More Gift Ideas
In addition to gifting your loved ones homes and cars, you can also make unlimited gifts in the form of tuition and other qualified educational expenses and medical expenses if you pay the learning institution or the care provider directly.
In other good news, you can make unlimited gifts to political organizations and to your spouse, provided your spouse is a U.S. citizen. But seriously, giving massive sums of money to political organizations is not the best use of funds. Look at Michael Bloomberg spending $1 billion on his presidential campaign and getting nowhere! What a waste.
Of course, how you spend your fortune is up to you.
Filing A Gift Tax Return
If you want to be a lawful American citizen, then you must file a gift tax return (Form 709) simultaneously with your regular tax return. Gift tax returns are due simultaneously with your regular tax return.
Here’s the thing. Less than 1% of Americans will accumulate an estate larger than the estate tax exemption limit, especially when the estate tax exemption threshold is $11.58 million per person (for 2020). Therefore, I’ve got to imagine that many citizens don’t even bother filing a gift tax return.
However, if your net worth is rocking in the tens of millions and up, you should probably get your records and taxes in order. If not, you had better at least donate enough money to charity so that your estate is right below the threshold.
As always, consult with your tax adviser before making any tax-related decisions. The rules are complicated and always changing. The last thing you want to do is make a mistake and have to file an amendment.
Manage Your Estate Better
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