Most people focus their tax planning efforts on minimizing the amount of income tax they pay. However, the federal gift tax can be even more onerous because of its 40% rate, and many people don't even know when they have to pay gift tax. Fortunately, there are provisions in the tax laws you can take advantage of to avoid paying gift tax, and most people will be able to take advantage of these provisions never to pay any gift tax at all.
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When you owe gift tax
Technically, the tax law imposes a gift tax on every single gift you make to someone else. The donor is the one responsible for paying the gift tax, not the recipient. Potentially taxable gifts include money, property, or the right to use or get income from property without receiving something of equal value at return. In addition, if you sell something for less than its full value or if you make a loan at no interest or with a reduced interest rate, then you might be making a gift.
That said, few people ever have to pay gift tax. That's because of the following exclusions and exemptions from the tax.
1. Annual gift tax exclusion
The tax laws grant everyone the right to make gifts up to a certain dollar amount each year. The purpose of the annual gift tax exclusion is to make it so that ordinary gifts like birthday presents aren't subject to the tax.
The amount of the annual gift tax exclusion is adjusted for inflation each year. In 2017, you can give up to $14,000 without incurring gift tax. The provision is on a per-recipient basis, so you can make individual $14,000 gifts to as many people as you choose. Because the provision is also on a per-donor basis, a married couple can give a total of $28,000 to each recipient under the annual gift tax exclusion.
2. Marital deduction
The gift tax laws allow married couples to transfer money and property between the two spouses freely. Therefore, you can generally give your spouse as much money or property as you want without having to worry about gift tax.
However, one thing that can trip people up is that the unlimited marital deduction is available only to U.S. citizens. Noncitizen spouses can only receive $149,000 each year in gifts. Anything above that level is subject to gift tax unless other provisions apply.
3. Gifts for education
Certain payments made for educational expenses qualify for a gift tax exclusion. In order to be eligible, the gift must cover tuition only. Gifts to cover the costs of books, supplies, room and board, or other educational costs don't qualify for this exclusion and must count toward annual exclusion amounts.
The key with this exclusion is that the donor must make the payment directly to the school. If you give the money to the student and the student then pays the tuition, you'll lose the exclusion.
4. Gifts for medical expenses
A donor can also give money toward covering medical care expenses or health insurance costs. However, the same limitation applies as for education: You must make the payment directly to the healthcare facility or health insurance company or else you lose the exclusion from gift tax.
5. Charitable deduction
Gifts to qualifying charities are exempt from gift tax. You can therefore make gifts of any size to tax-exempt organizations under Section 501(c)(3) of the Internal Revenue Code.
6. Unified lifetime exemption from gift and estate tax
The five provisions above take care of the vast majority of people's potential gift tax liability. However, even if you do make a larger gift, the reason so few people ever pay gift tax is the lifetime exemption. Over the course of your lifetime, you're entitled to a credit against gift and estate tax that you incur. The amount of that credit rises for inflation every year, and for 2017, the amount is equal to the gift tax on gifts of $5.49 million.
What that means is that even after you give $14,000 in annual gifts to everyone, unlimited gifts to a spouse or charity, and unlimited gifts toward medical or educational expenses, you can give up to an additional $5.49 million without having to pay gift tax. However, to use the credit, you have to file a gift tax return on Form 709. Also, whatever you use reduces the unified credit you have left for your estate to use after your death, but that's a small price to pay to avoid the IRS's grip now.
Be tax-smart about gifts
Most people don't have to pay gift tax, but it's important to understand why. That way, if you do make what might be taxable gifts, you'll know what your obligations are and what impact it might have on your long-term estate planning.
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