Introduction
The gift tax is a federal tax that applies when money or property is transferred to another person without receiving equal value in return. This differs from the estate tax, which applies to the transfer of assets held at the time of death.
The gift tax was enacted, in part, to prevent one from giving away all of their assets while on their deathbed, thus avoiding the estate tax.
Gift Tax vs. Estate Tax
There are three important differences between the gift tax and estate tax:
- There is an annual gift tax exclusion from the gift tax.
- Payments for qualified educational expenses and qualified medical expenses are exempt from the gift tax.
- Gift tax payments are tax exclusive while estate tax payments are tax inclusive.
What is the Gift Tax Rate?
The gift tax rate is 40% – the same as estate tax. The unified credit is what ties the two together.
The amount of the unified credit is first applied to gifts made during your lifetime. Any remaining unified credits will apply at death to avoid (or reduce) your estate tax.
What Is the Annual Gift Tax Exclusion?
The annual gift tax exclusion (typically called the “annual exclusion”) is a fixed dollar amount that can be given to as many people as a person wants each year without using up unified credit or causing a gift tax to be due. The amount of the annual exclusion has changed over time.
In 2023 the annual exclusion amount is $17,000 and is only available for lifetime gifts (not at death).
Exemptions for Qualified Educational Expenses
To encourage education payments of tuition expenses made directly to the educational institution do not count as gifts for gift tax purposes. For example, college tuition paid directly to the school in the amount of $60,000 exceeds the annual gift tax exclusion, but it’s exempt from gift tax altogether. In that circumstance, the parent could also make an annual exclusion gift of $17,000 to the child.
If, however, a parent puts the tuition money directly into the child’s bank account this transfer is considered a gift exceeding $17,000 – causing the excess to be a taxable gift. In other words, tuition payments must be made directly to the college to be considered qualified (1). Tuition can be paid for the present school year and future years, but payment of future years’ tuition cannot be refundable (if child drops out).
Pre-payment of college (or primary or secondary private school) tuition may be an option for significantly reducing the taxable estate of a person who will die in the near future. A person’s estate can be greatly reduced if he or she pre-pays tuition for four or five grandchildren just before passing. There is no equivalent exception for these types of expenses if payment is made at death.
(1) This exception applies only to tuition – not room and board, books, etc.
Exemptions for Qualified Medical Expenses
Payment of qualified medical expenses directly to the medical provider also avoids being treated as gifts, no matter the amount. The same applies to payment of medical insurance expenses directly to the insurance company (2).
There is no equivalent exception if payment for these types of expenses is made at death.
(2) Qualified medical expenses do not include elective surgery for cosmetic purposes such as a tummy tuck, liposuction, or nose job (unless necessary to help breathing or mend an injury), etc. These are treated as gifts for gift tax purposes.
Gift Tax As “Tax Exclusive” Vs. Estate Tax As “Tax Inclusive”
When gift taxes are owed during an individual’s lifetime, the funds used for payment are no longer “owned” by that person at the time their death. Thus, gift tax payments reduce the total transfer tax (gift and estate tax) due upon death. This benefit does not apply to estate taxes, however, as the funds used for payments are typically subject to estate tax themselves.
The gift tax and the estate tax rates are both 40%, but to illustrate why the gift tax is actually “cheaper” than the estate tax, consider the following examples:
Example 1
Assume Dad has $100 and gives $20 to his child during life. At a 40% rate, an $8 gift tax is due. After paying the gift tax, Dad has $72 in his pocket at death. Now, assume Dad dies and leaves that $72 to his child. If the 40% estate tax is imposed on the $72, there is $28.80 of tax due – payable out of the $72, leaving $43.20 for the child to inherit. When the $20 gift received previously is added to the $43.20 inherited at death, the child has received – “net to heirs” – $63.20.
Example 2
Now assume no gifts were made during life and at death $100 is left to the child. The 40% estate tax applies and net to heirs is $60. That amount is $3.20 less than in the previous example where dad made the $20 gift and paid gift tax during life. The gift tax paid was $8. At a 40% gift tax rate, the $3.20 of the estate tax on that $8 is avoided because the $8 was used to pay gift tax and therefore wasn’t included in dad’s taxable estate at death. In other words, the child pockets the extra $3.20 as a result of the gift – the transfer (estate) tax on the funds used to pay the ($8) gift tax is avoided in the context of the gift.
Income Tax Basis Considerations For Gifts
Income tax “basis” is the figure against which capital gain is calculated. If you buy something for $8 and later sell it for $15, you pay income tax on $7 – the difference between your “basis” (i.e., what you paid for the asset) and the sales price.
At death, however, the rule is that beneficiaries receive their inheritance with a “stepped up” basis. In the example, above, your heirs would receive the asset with a $15 basis at your death. If they later sold it for $15 there is a capital gain of $0 and no capital gain tax due.
For gifts, the rule is different. The donee’s gift takes a “carryover basis” in the asset – that is, the same basis the donor had when he owned the asset. In our example, if the donee was gifted the $15 asset during donor’s life, donee also takes the $8 basis, and on a subsequent sale would pay capital gains tax on the $7 gain.
Therefore, transferring property at death is better than making a gift during life. When making gifts, the loss of the basis “step-up” must be taken into consideration. Gifting assets with a high basis makes more sense than gifting assets with a low basis. Gifting assets that you never intend to sell (e.g., legacy property, or the Picasso) makes more sense than gifting assets that are likely to be sold after you die. And gifting assets that are certain to be sold during the donor’s lifetime also makes more sense than gifting assets that are not likely to be sold before a donor passes (3).
(3) Always work with your legal and tax advisors for basis planning in the context of wealth transfer tax strategies.