Understanding the Gift Tax Rules and Why They Are Important – Part I

A gift is a transfer of property or property interests without adequate consideration. Gifts can include transfers of cash or property, payments made to third parties on behalf of another individual, interest-free loans, below-market sales and the creation of certain joint tenancies. Most transfers of property or property interests without adequate consideration are subject to the federal gift tax.

The federal gift tax was enacted in 1924 as a backstop to the federal estate tax in order to prevent wealthy Americans from shrinking their taxable estates by transferring assets to other individuals, especially family members, before their death.

The federal gift tax kicks in above a lifetime exemption that applies both to an individual’s total taxable gifts made during life and assets left at death. Currently during 2023, the top federal estate and gift tax rate is 40 percent. Note that it is the gift donor (not the gift donee) who is liable for paying any federal gift tax.

For 2023, the combined federal gift and estate tax exemption is $12.92 million per individual, or $25.94 million per married couple. Since the lifetime exemption is indexed for inflation, all but the wealthiest Americans are subject to the federal estate and gift tax.

What Constitutes a Gift?

A gift is the transfer of cash, assets or anything of value “for less than adequate and full consideration.” “Consideration” often means money, but it could be other assets. The following two examples illustrate a gift.

Example 1. Grandpa writes a check for $10,000 to his granddaughter to help her pay her fall semester college tuition bill. The $10,000 is considered a gift.

Example 2. Mike, age 62, owns a car repair shop. The car repair shop is worth about $1.8 million. Mike decides to sell his car repair shop to his son, Darryl for $1.2 million. The $600,000 difference of what the business is worth compared to what Darryl paid for the business is considered a $600,000 gift.

Annual Gift Tax Exemption

In addition to the lifetime gift tax exemption (discussed above), each individual can make tax-free gifts annually to other individuals, whether they are related or not. For 2023, the limit of the gift that one individual (the “donor”) can make to any other individual (the “donee “) (whether they are related or not) is $17,000 and is not subject to the gift tax. For example, a married couple with two married children and three grandchildren could give a total of $238,000 tax-free gifts during 2023. The $238,000 tax-free gifts are the result of the married couple “splitting” their gifts – each spouse gifts $17,000 – a total of $34,000 – times seven individuals (two children, the children’s spouses, and three grandchildren, for a total of seven individuals) times $34,000 equals $238,000. The married couple can additionally gift $34,000 during 2023 to as many individuals as they want. No United States Gift Tax return (IRS Form 709) for the year 2023 need be filed for annual gifts below the $17,000 threshold per individual during 2023.

Gift “Splitting”

With a married couple, if one spouse owns most of the couple’s assets, then during 2023 that spouse could gift to any individual the combined exemption of $34,000. This is called “gift-splitting.” A US Gift Tax return (IRS Form 709) needs to be filed in the spring following the year of the “gift splitting” and should be filed, even though there most likely no gift tax liability.

Gifting to 529 Education Savings Plans

Individuals can bunch up to five years of maximum annual gifts (five times $17,000 or $85,000 during 2023) and contribute the cash to a 529 education-savings plan for the benefit of someone, such as a child or a grandchild, with no gift tax consequences. The following example illustrates:

Example 3. Charles and Rachel are retired and have one grandchild, Rudy, who is 10 years old. During 2023, Charles and Rachel decide to contribute to a 529 education-savings plan on behalf of Rudy. They decide to bunch five years of annual gifts during 2023. This means that through “gift-splitting,” Charles and Rachel will contribute a total of five years times $34,000 per year, or $170,000 to an education savings plan on behalf of Rudy.

Charles and Rachel will have to report the $170,000 contribution to an education-savings plan on IRS Form 709 for tax year 2023. While there will be no gift tax due, the gift nevertheless has to be reported to the IRS.

Gift Tax Returns (IRS Form 709)

A United States Gift Tax return (IRS Form 709) is not required for:

• Gifts of any amount to a spouse who is a US citizen. This does not include a gift which is a terminable interest. A terminable interest gift is a gift that will end at some point in the future, such as estate or income interests in a trust.

• Gifts to a spouse who is not a US citizen if:
(1) the spouse received no more than $175,000 during 2023.
(2) No gift was a terminable interest.
(3) No gift was a future interest gift. A future interest gift is a gift that delays the income or enjoyment until a specific time in the future.

• Gifts directly made to charitable organizations.

• Gifts to anyone else assuming that no one individual recipient received more than $17,000 (2023), $34,000 for a married couple who are “splitting” their gifts, and that no gift was a future interest gift.

The following example illustrates the use of the gift-tax exclusion, “gift splitting,” and the coordination of the federal estate and gift tax exemptions. The example involves a married couple helping a child and the child’s spouse buy their first home during 2023. With the high cost of real estate in many areas of the country, it is not uncommon for parents to monetarily assist their children with the downpayment, closing costs, and necessary acquisitions to make the home more affordable and more comfortable.

Example 4. Frank and Donna are married. They have a son, Oscar, who is married to Olivia. Oscar and Olivia are hoping to purchase their first home, costing $750,000. In order to avoid paying private mortgage insurance (PMI), Oscar and Olivia will need to make a downpayment of 20 percent or $150,000. They will also need $50,000 to pay closing costs. Oscar and Olivia have $25,000 in savings and have asked Frank and Donna for assistance in obtaining the $200,000 less $25,000, or $175,000 needed to purchase the home. Frank and Donna said that they will gift the $175,000 to Oscar and Olivia as follows:

(1) $34,000 “split-gifts” to both Oscar and Olivia, a total of $68,000. These gifts are federal gift-tax free.

(2) $53,500 gift to both Oscar and Olivia, a total of $107,000. These gifts must be reported on IRS Form 709 for the year 2023. While each $53,500 gift is subject to the gift tax, there will be no gift tax payable by Frank and Donna. This is because $53,500 will be deducted from both Frank’s and Donna’s $12.92 million gift tax exemption.

Finally, there are other gift-tax reporting requirements besides the $17,000 ($34,000) gift limit during 2023. Payments made by one individual to help pay the college tuition and fees of another individual, or the medical bills of another individual, are gift-tax free and do not have to be reported on IRS Form 709.

However, to qualify, these payments must be made directly to the college/university/private or parochial school, or to the medical care provider. If these payments to pay education tuition and fees or the medical bills are made from the donor to the donee, then the payments are considered gifts and must be reported on IRS Form 709.

For more information about gifting and estate planning, federal employees and retirees are advised to speak with an estate attorney licensed to practice in their state of residence.