Every taxpayer has two options for dodging the gift tax. The first is an annual exclusion, and you're also allowed a lifetime exemption.
What Counts As a Gift?
The Internal Revenue Service considers a gift to be virtually any transfer of cash or property in which the donor doesn't receive something of equal value in return. If you give someone cash with the understanding that he does not have to pay you back, that's a gift. If you sell someone a $300,000 home for $150,000, you've made her a gift of $150,000.
Another important consideration is that not all gifts are taxable. Dad could pay his son's tuition bills or medical expenses in any amount without incurring a gift tax, provided he gives the money directly to the learning institution or the medical facility, not to his son.
The Annual Gift Tax Exclusion
It all starts with the annual exclusion, which lets you make gifts of up to $15,000 per year per person tax-free as of 2019. These gifts don't count against your $11.4 million lifetime exemption.
The key words here are "per person." If your son and his spouse want to buy a house and you want to give them $30,000 for a down payment, you can do that without paying a gift tax. You can attribute $15,000 for that year to each of them. The IRS doesn't care whether they both spend the money on the same thing.
When and Why You Must File a Gift Tax Return
You must report gifts over the annual exclusion to the IRS on Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return. This records how much you've gone over the annual exemption each year—the amounts that count against your lifetime exemption.
The Lifetime Exemption Is a "Unified" Credit
The IRS lumps together all gifts you make during your lifetime with gifts you make as bequests from your estate when you die. The gift tax and the estate tax share this same $11.4 million exemption under the umbrella of something called a unified tax credit.
If you exceed your annual exclusions to the tune of $1 million during your lifetime, you'll have $10.4 million left to shelter your estate from estate taxes when you die.
Of course, $11.4 million is a lot of money. Only two out of every 1,000 estates owed any estate tax in 2017—and the annual exemption that year was roughly half the 2018 exemption, just $5.49 million.
A Gift Tax Example
If a father makes a gift of $115,000 to his son for the purchase of a home, $15,000 of that gift is free and clear of the federal gift tax, thanks to the annual exclusion. The remaining $100,000 is a taxable gift and would be applied to his lifetime exemption if he chose not to pay the tax in the year he made the gift.
You can give the annual exclusion amount to any one person every single year and never dip into your lifetime exemption. If the father doesn't want to pay the gift tax on the $85,000 in the year the gift is made, he can reduce his lifetime gift tax exemption by this amount. Despite his significant generosity, Dad would still have $11,315,000 of the unified tax credit left to shelter his estate.
Another Option for Payment
The IRS isn't entirely without a heart, and it encourages generosity to some extent, giving you yet a third option. If you give gifts in excess of the annual exclusion, a special rule lets you spread their value out over five years, another way of effectively paying the tax now so that you don't have to dip into your lifetime exemption.
He's whittled his taxable gift down to just $25,000, on which he can either go ahead and pay the gift tax or let it count against his lifetime exemption.
Exemptions Increase Periodically
The lifetime exemption increases periodically to keep pace with inflation and due to changes in legislation. The 2017 lifetime exemption of $5.49 million increased from $5.45 million in 2016 with inflation adjustments, then it went from $5.49 million to $11.18 million in 2018, thanks to the Tax Cuts and Jobs Act and another inflation adjustment.
This information is not intended to be tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek tax or legal advice from an independent professional advisor.