If you make very large gifts during your lifetime, you may owe federal gift tax. But don’t worry too much about gift tax: the vast majority of Americans never need to pay it, because most ordinary gifts aren’t taxed.
State gift taxes. Only two states, Connecticut and Minnesota, impose their own gift tax. Connecticut gift tax is owed when the value of all taxable gifts made by a resident since 2005 (not counting out-of-state real estate) reaches $2 million. Minnesota has a $1 million gift tax exemption.
How the Federal Gift and Estate Tax Work Together
The federal gift tax is part of what’s called the “unified” federal gift and estate tax. Gift tax applies to lifetime gifts; estate tax applies to assets left at death. The idea is that whether you give assets away while you’re alive, or leave them at your death, they’re taxed the same way, at the same rate. (If there were no gift tax, then anyone could completely avoid the estate tax by giving everything away just before death.)
Under current law (for deaths in 2015), each of us can give away or leave up to $5.43 million without owing federal gift and estate tax. So, for example, if during your life you give your children your house, worth $1 million, plus another $4 million in stocks and bonds, no federal gift tax will be due. The exemption amount is indexed for inflation and goes up each year.
In addition to the $5.43 million exemption, many other gifts are not subject to the gift tax—for example, gifts to a spouse. So if you give your $1 million house and $4 million of other property to your children, and another $7 million to your spouse, you still won’t owe any gift tax.
Gift Tax Basics
If a gift is taxable, the person who makes the gift—not the recipient—must file a gift tax return and pay any tax owed. However, very few people end up paying gift tax during life because gift tax is not owed until your cumulative taxable gifts exceed the $5.43 million exemption. Very few people give away that much money during their lives.
At someone’s death, federal estate tax is calculated. In addition to the property left behind (the estate), the amount of taxable lifetime gifts is included in the total that may be subject to estate tax. Again, no tax is due unless the taxable estate exceeds the exempt amount.
What’s a gift? A gift is any transfer for which you receive nothing, or less than “fair market value,” in return. For example, if you hand someone a check for $1,000, that’s a gift. And if your house would fetch $100,000 on the open market but you sell it to your son for $10,000, you’ve made a $90,000 gift to him.
What’s "fair market value?" The fair market value is the price at which an asset would sell when there’s a willing and knowledgeable buyer and seller.
What’s a taxable gift? Lots of ordinary gifts are NOT taxable, including:
- Gifts that are not more than the annual exclusion amount, $14,000 in 2015 (you can give this amount to any number of different recipients; you and your spouse can give $28,000 per year per recipient)
- Tuition, if you pay it directly to the school (other expenses related to education, such as books, supplies and living expenses, do not qualify for this exemption)
- Medical expenses you pay directly
- Gifts to your spouse (if your spouse is a U.S. citizen)
- Gifts to a political organization for its use
- Gifts to certain charities
What’s the gift tax rate? The current federal gift/estate tax rate is 40%.
Filing a Federal Gift Tax Return
If you make a taxable gift—for example, you give your daughter $25,000 to help her buy a house—then you’ll need to file a gift tax return (IRS Form 709). This isn’t a do-it-yourself project; hire an experienced attorney, enrolled agent (EA), or certified public accountant (CPA). (Or better yet, structure the gift so it isn’t taxable. See “Reduce Estate Tax by Making Gifts.”)
If you are wealthy enough to be concerned about the federal gift and estate tax, you may end up hiring more than one professional adviser. It’s common for an attorney to help a family craft an estate plan, while an EA or CPA prepares tax returns and helps deal with the IRS.
For more about the federal gift and estate tax, see IRS Publication 950, Introduction to Estate and Gift Taxes.