Gift Tax 101: What You Need to Know

AdobeStock_502074078-300x169Giving gifts is a nice thing to do for a friend or family member, but, as the saying goes, “no good deed goes unpunished” – at least when it comes to the IRS.

The federal government imposes a gift tax that is currently 40%. And if you live in Connecticut, your gift may also be subject to the one-and-only state-level gift tax in the country. Lucky you.

The good news is that because of the annual and lifetime gifting exemptions as well as several categories of gifts that are not subject to the gift tax at all, the majority of Americans will rarely (if ever) have to pay a gift tax. 

Still, it’s better to be safe than sorry, which is why we’ve compiled this Gift Tax Guide to help you understand when the tax does and doesn’t apply, when it’s actually a good idea to pay the gift tax, and what changes might be in store in 2023.

Gift Tax & Lifetime Exemptions

Everyone has a lifetime exemption available for gift and estate taxes, which applies in cases involving certain transfers to individuals other than spouses who are US Citizens. 

The basics of the gift tax are as follows (based on 2022 rates and figures):

Federal Gift Tax:

  • Maximum Federal Gift Tax Rate: 40%
  • Annual Exemption: $16,000 per year per person 
    • (You and your spouse can combine your exclusions to jointly give up to $32,000 per person per year. This is sometimes referred to as “gift splitting.”)
  • Lifetime Tax-free Exemption: $12.06 million

Connecticut Gift Tax:

  • Connecticut State Gift Tax Rate: 11.6% (if the value of the taxable estate/gift is $9.1 to $10.1 million) or 12% (if the value is greater than $10.1 million)
  • Annual Exemption: $16,000 per year per person
    • (You and your spouse can combine your exclusions to jointly give up to $32,000 per person per year. This is sometimes referred to as “gift splitting.”)
  • Lifetime Tax-free Exemption: $9.1 million

The annual exemption applies to each calendar year, meaning you can give up to $16,000 to as many people as you want without triggering the requirement of filing a gift tax return or paying any gift tax. 

Let’s look at an example:

Say you give your child $10,000 to help pay off a credit card. That is a gift.

Is it a taxable gift?

No, because it is less than $16,000. End of story.

But let’s say you give your child $60,000 to help pay off their mortgage. That is a gift. 

Is it a taxable gift?

Yes, but only to the extent that it exceeds the $16,000 annual exemption. So $44,000 out of the $60,000 gift is a taxable gift.

Do you have to pay a gift tax?

No, because you have that federal lifetime exemption described above. In this example, you would have only used up $44,000 worth of your respective state and federal exemptions, meaning you could make an additional $12,016,000 before you would have a federal gift tax liability. 

However, you still need to file a gift tax return even if you haven’t exhausted your lifetime exemption because your estate tax exemption is reduced by the same amount. So if you gift $1 million, you will have $11 million to leave tax-free to the kids. (The IRS likes to track this for us.)

Gifts Subject To The Gift Tax

AdobeStock_288549851-300x200Before we go any further, let’s define our terms — what exactly is a gift?

In the simplest terms, when you give a gift, you transfer something of value to another person. The gift might be cash, or it might be an asset. It can also be an asset that you sell to the other person for less than the item’s fair market value. (For example, if you charge your grandchild only $5,000 for a car that’s worth $10,000, the difference of $5,000 is considered a gift.)

Outside of giving cash, there are a number of other ways to give financial gifts that the IRS considers taxable:

  • Checks. In order to keep people from writing out a slew of large checks on their deathbed (in order to avoid estate taxes), the federal gift tax does apply to checks and the gift is considered effective on the date the donor presents the check. 
  • Loaning amounts of $10,000 or more at an interest rate below the going market rates. In such a case, the gift tax is calculated based on the difference between the interest rate charged and the corresponding federal rate.
  • Canceling indebtedness. While this may not immediately seem like a direct gift, for tax purposes it is considered one.
  • Adding a joint tenant to real estate. In this case, the gift tax kicks in if and when the new joint tenant has the right (under state law) to sever his interest in the joint tenancy and, as a result, take ownership of half the property. (Whether the joint tenant exercises that right or not is irrelevant. It just has to be in place.)
  • Making a payment on debt owed by someone else constitutes a gift to the debtor. 
  • Gifts of real estate. Any gift of foreign real estate from a U.S. citizen (whether or not the recipient is also a U.S. citizen) is subject to the gift tax for any property value above and beyond the annual gift exclusion. In addition, any gift of U.S. property is subject to the federal gift tax even if both parties are nonresidents. Such nonresidents are given the same $16,000 annual exclusion, and they are also able to exclude property gifts to spouses. They are not, however, granted the $12.06 million lifetime exclusion.

Just remember that gifts that fall into these categories are only taxable if they fall outside of the annual and lifetime exceptions stated earlier. 

Gifts Not Subject To The Gift Tax

While we’re defining terms, it’s also helpful to understand when a gift is not a gift. There are several types of “gifts” that aren’t considered taxable and so do not count toward either your annual or lifetime total exclusions:

  • Charitable gifts to registered nonprofit organizations
  • Money given to a spouse who is also a U.S. citizen (Annual limits apply to foreign spouses)
  • Money to cover education tuition. Such gifts must be made directly to the educational institution, not the individual, and out-of-pocket expenses like books, supplies, and living expenses are not qualified expenses. It’s important to also note that payments into 529 state tuition plans are also considered gifts. However, a special rule can apply to permit a single one-time contribution to a 529 plan to be treated as if it were made over a five year period. So, a single $80,000 contribution would not exceed the gift tax exemption provided you do not make any additional gifts to the benefiting individual in the following 4 years.
  • Money for medical expenses. As with gifts for education, these must be paid directly to the person or institution providing care. Qualifying expenses include diagnosis and treatment of disease, medical and long-term care insurance, transportation that is primarily for medical care, and a number of medical procedures.
  • Bonafide business transactions. If you buy an item and you had a valid business purpose for the purchase, it will not be considered a gift if you discover later on that you inadvertently paid more than fair market value for the item.
  • Jointly owned bank or brokerage accounts or U.S. Savings bonds. It is not considered a gift at the time another name is added as a joint owner.  However, you WILL be treated as having made a gift at the time that joint owner withdraws funds later on.
  • “Present-interest” gifts up to the amounts specified by the annual exclusions noted above.
  • Gifts to minors. Since a parent’s support payments for a minor’s living expenses are considered a legal obligation, they are not considered gifts and are not subject to the gift tax.  However, direct gifts and gifts made through a custodial accounting above and beyond living expenses are subject to federal gift tax. (All the same standard and annual lifetime exclusions would still apply.)

A word of warning, if you or your spouse are applying or plan to apply for Medicaid (Title 19), the usual exceptions do not apply.  Medicaid penalizes just about all gifts, even those exempt from the federal and Connecticut gift tax.

When It’s a Good Idea to Pay The Gift TaxAdobeStock_267044407-300x200

While most people instinctively want to avoid paying more taxes, there are actually some instances when paying the gift tax may work out in your favor in the long term.

Suppose, for example, that you are thinking of gifting $224,000 to your four children, but—because you’re worried about the gift tax taking a large cut—you’re also considering holding onto the money until you die.

Which option will be better for your children?

Let’s look at the math.

Scenario 1: You hold onto the $224,000 for 15 years in an account that earns 7% each year. At the end of the 15 years, you will have $618,000 in your estate and. At a 40% estate tax rate, your executor will have to pay $247,000 in federal estate taxes. End result: your children get $371,000.

Scenario 2: You pay the gift tax on the $224,000, which after deducting the $16,000 annual exclusion for each child, is $160,000. The gift tax is $64,000 and your children receive the remaining $160,000. Your children invest the money at the same rate of 7% for 15 years, at the end of which, they have $441,000, all of which they get to keep since the estate tax will not apply.

This is an example in which paying taxes actually earns you (or, technically, your children) $70,000.

Changes Coming in 2023 and Beyond

Transferring assets during your lifetime or when you pass away is often a challenging endeavor, which is made more complex because the IRS (and the state of Connecticut) want their share. These agencies use the gift tax (lifetime transfers) and the estate tax (transfers at death) to make sure they don’t leave any money on the table. 

What makes things even more confusing is that the laws about the gift and estate taxes often change.

As we’ve outlined here, everyone has annual and lifetime exemptions available for gift and estate taxes. In 2022, the federal gift and estate tax exemptions were $12.06 million, and the Connecticut gift and estate tax exemptions were $9.1 million. In 2023, these exemptions will increase. The federal AND Connecticut exemptions will be $12.92 million.

Additionally, the annual exclusion will increase from $16,000 to $17,000. This means an individual may gift $17,000 per person to unlimited recipients without reducing lifetime exemptions. 

However, in 2026, the federal and Connecticut lifetime and estate exemptions are expected to drop to about $6 million. 

The good news is that there are ways to mitigate or eliminate estate tax exposure. If you’re concerned about gift and estate taxes and are thinking about moving assets out of your name, we can help. Give us a call. We’d be happy to give you some guidance.

Related Posts:

Gifts and Taxes: 7 Gifts That Are Not Taxable

8 Ways to Gift Assets to Your Grandchildren

7 Smart Gift-giving Strategies for Your Estate Plan

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