Updated January 1, 2014
By far the most misunderstood tax that I find in my estate planning practice is the U.S. federal gift tax. Many people do not understand that they simply cannot give their property away without incurring any tax consequences, not to mention the fact that they may also disqualify themselves from Medicaid eligibility for several months or even years.
Some of the confusion stems from the fact that there are in fact two "exclusions" or "exemptions" that apply to federal gift taxes, one that can only be used on an annual basis and the other which can be spread out over a person's entire lifetime. The former is commonly referred to as the "annual gift tax exclusion" and the other is commonly referred to as the "lifetime gift tax exemption."
What is the Annual Gift Tax Exclusion?
With regard to U.S. gift taxes, the annual gift tax exclusion is the amount that can be given away by an individual in any given year to an unlimited number of people free from any federal gift tax consequences at all. In other words, a once a year gift or even a series of gifts made to the same person during the course of one calendar year that do not exceed the annual gift tax exclusion are not really considered gifts at all. Instead, they are considered as "freebies" when it comes to federal gift taxes. For 2012 the annual gift tax exclusion was $13,000, and it increased to $14,000 in 2013 and will remain at $14,000 in 2014.
For example, you could give $5,000 to your daughter in January 2014, another $5,000 in June 2014, and then another $4,000 in December 2014, and since the total amount of gifts made to your daughter during the 2014 calendar year only equals $14,000, the "gifts" to your daughter will actually not be considered gifts at all for federal gift tax purposes. You can also give your son a car worth $14,000 in 2014, each of your grandchildren stocks worth a total of $14,000 each in 2014, and your best friend a diamond ring worth $14,000 in 2014, and, again, each and every "gift" will actually not be considered a gift at all for federal gift tax purposes.
What is the Lifetime Gift Tax Exemption?
In contrast, with regard to U.S. gift taxes, the lifetime gift tax exemption is the total amount that can be given away by an individual over his or her entire lifetime to any number of people that will be free from gift taxes, but the amount gifted will in turn reduce the amount that can be given away by the individual at death free from U.S. federal estate taxes. In other words, the lifetime gift tax exemption is tied directly to the federal estate tax exemption so that if you gift away any amount of your lifetime gift tax exemption, then this amount will be subtracted from your estate tax exemption when you die.
Under the provisions of the American Taxpayer Act of 2013 (or ATRA for short), the lifetime gift tax exemption will equal the federal estate tax exemption and will be indexed for inflation in future years. Thus, while the lifetime gift tax and estate tax exemptions were each $5,120,000 in 2012, the exemptions increased to $5,250,000 in 2013 and increased to $5,340,000 on January 1, 2014.
Confused? Don't be. An example will help to explain the concept: If an individual gives away $3,000,000 during his or her lifetime and then individual dies in December 2014, then the individual's federal estate tax exemption will only be $2,340,000. In other words, $3,000,000 in lifetime gifts is subtracted from the 2014 federal estate tax exemption of $5,340,000, which only leaves $2,340,000 of the exemption.
What Happens if You Make a Taxable Gift?
What happens if during the course of 2014 you make a total of $120,000 in gifts to your daughter? Then you will have made a taxable gift to your daughter equal to $106,000:
$120,000 in gifts reduced by the $14,000 annual gift exclusion equals $106,000 in taxable gifts.
In turn, the $106,000 in taxable gifts will reduce your 2014 $5,340,000 lifetime gift tax exemption down to $5,234,000:
$5,340,000 lifetime gift tax exemption reduced by $106,000 in taxable gifts equals $5,234,000 of lifetime gift tax exemption remaining.
Taxable gifts must be reported to the IRS on Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return. The return is due on the same date as your personal income tax return, meaning on April 15 of the year after the year in which the taxable gifts are made.
Special Gift Tax Rules
Aside from annual exclusion gifts and the lifetime gift tax exemption, there are some special U.S. gift tax rules that you need to be aware of, including some types of gifts that are not considered gifts at all (meaning they are true "freebies"), rules that apply to gifts made by a U.S. citizen to a spouse who is not a U.S. citizen, and the unlimited marital deduction which applies to gifts made by a U.S. citizen to a spouse who is also a U.S. citizen:
The Bottom Line On Taxable Gifts
What is the bottom line when it comes to making gifts? If you are not sure if you are about to make a taxable gift, then consult with your accountant or estate planning attorney to be sure so that you are not surprised by the gift tax consequences after the fact. Or, if you are not sure if you have already made a taxable gift that should be reported to the IRS, then consult with your accountant or estate planning attorney to determine if and when you need to file IRS Form 709.