Very few Americans need to worry about federal estate tax (see Estate Tax: Will Your Estate Have to Pay?) or the federal gift tax. For deaths in 2016, everyone has a lifetime gift and estate tax exemption of $5.45 million, which means you can leave or give away up to $5.45 million without owing any federal tax. This amount goes up every year to adjust for inflation. Married couples can together leave up to twice that amount free of federal estate tax. (Some states, however, impose their own estate tax on smaller estates. See Estate and Gift Tax FAQ.)
If you do think your estate might owe estate tax, one way to avoid or reduce the tax bill is to give away property during your life. And even if you aren't concerned about estate tax, gifts offer other benefits -- you also get to see the recipients enjoy your gifts.
In 2016, you can make an unlimited number of $14,000 gifts of cash or other property, completely tax-free. To ensure these tax savings, you need to remember only that no individual recipient can receive more than $14,000 in a calendar year.
How the Annual Exclusion Works
The $14,000 annual tax exemption rule (called the "annual exclusion") is pretty straightforward. For instance, if you give $20,000 to someone, $14,000 of it is exempt from gift tax, but you must pay gift tax on the remaining $6,000.
The exclusion amount is indexed for inflation, rising in $1,000 increments as the cost of living goes up.
Couples: Double Your Exclusion
Couples can combine their annual exclusions, meaning that they can give away $28,000 worth of property tax-free, per year, per recipient. In fact, even if only one spouse makes a gift, it's considered to have been made by both spouses if they both consent. (Internal Revenue Code § 2513.)
Joe and Faye, a couple in their 70s, want to give their son and his wife money for a down payment on a house. Both Joe and Faye take advantage of their $14,000 exemptions to give a total of $28,000 to their son and another $28,000 to his wife. As soon as the first of the year rolls around, they can give away another $56,000.
Gifts to Your Spouse
All gifts you make to your spouse are tax-free, as long as he or she is a U.S. citizen. If your spouse isn't a citizen, the limit on tax-free gifts is $148,000 in 2016. (Internal Revenue Code § 2523(a).) However, there's seldom a reason to make large gifts to your spouse. If you each own about the same amount of property, you could worsen your tax situation by saddling your spouse with an estate that's so large it will be taxed at his or her death.
Timing Your Gifts
To make the most of the annual exemption, keep in mind that it is based on a calendar year. If you miss a year, you can't go back and claim that year's exemption amount. But if you spread a large gift over two or more years, you may escape gift tax complications. For instance, if you give your daughter $20,000 on December 17, $6,000 of it is taxable. You'll have to file a gift tax return (by April 15 of the next year), and you'll use up $6,000 of the total amount you can give away or leave free from estate tax. But if you give your daughter $10,000 in December and wait to hand over the other $10,000 until January 1, both gifts are tax-free.
Giving Away Non-Cash Property
Not only gifts of cash can be spread over several years. You can give away some stocks now, some next year. You can even give real estate in pieces -- physical pieces, if that's possible, or pieces (percentages) of ownership.
Solomon and his wife Rhoda want to give their vacation cabin to their son Gerard. The cabin has a fair market value of $75,000, but their equity is only $40,000 because there is still $35,000 left on the mortgage. In November, Solomon and Rhoda sign a deed transferring the cabin to Rhoda and Gerard as joint tenants, meaning that Rhoda and Gerard each own a one-half interest in the property. (Solomon gave Gerard his $20,000 share of the equity in the cabin.) Gerard's gift from his parents is tax-free, because together they can give him up to $28,000 tax-free each calendar year.
The next calendar year, Rhoda gives her half-share, worth $20,000, to Gerard. Even though only Rhoda makes the gift, the IRS considers it, for tax purposes, to have come from both spouses.
Gifts to Children
Giving children valuable property before they are adults raises the important question of who will manage the property for the child. If you give a large gift to a child under 18, an adult must be responsible for the money.
Fortunately, it's easy to arrange for an adult to manage the property, by setting up either:
- an irrevocable child's trust, or
- a custodianship authorized by state law.
To learn more about leaving gifts through trusts and custodianships, see Nolo's article Leaving an Inheritance for Children.
To qualify for the annual exclusion from gift tax, a gift to a minor must satisfy these conditions:
- The recipient must receive the property outright by age 21. This means that if you set up a custodianship for your child, it must end when the recipient turns 21. That said, the property and its income may of course be spent by, or for the benefit of, a recipient who isn't 21 yet. Similarly, if you create a trust for the child, the trust document must state that the property will be turned over to the recipient by his or her 21st birthday. (But you may also give the recipient the right to extend the trust.)
- If the recipient dies before age 21, the remaining property must go to the recipient's estate or to someone the recipient named -- for example, in a will. (Internal Revenue Code § 2503(c).)
Think Before You Give
An ambitious program of gift-giving is not for everyone. If parting with assets makes you feel vulnerable or fearful that you will someday be without money you need, don't do it. Or you may decide that your children or grandchildren are not ready yet to appreciate your generosity. But helping a 21-year-old get an education, or new parents buy a house, can give you great satisfaction.
One reason that planned gift-giving has gained in popularity is that people live so much longer than they used to. If you wait until you die to transfer your wealth, the recipients -- for most people, their children -- may be nearing old age themselves. Your financial help may be more useful when they are younger.
If you want to learn more about the gift tax and other estate planning strategies, read Plan Your Estate, by Denis Clifford (Nolo).