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The federal government has a gift tax structure so that people may not give away a large amount of assets and avoid having these assets taxed at death.
There are a number of exceptions to the gift tax, but in doing any planning people should understand the gift tax system and be aware of the advantages and disadvantages of making gifts.
The value of assets for gift tax purposes is the fair market value as of the date of gift. This is what an asset may be sold for on that date. If a person gives 100 shares of stock to his son and the stock is selling for $15 per share on the date of gift, the value of the gift is $1,500. The income tax basis for the stock is separate and is covered below.
Every person may give up to $11,000 of cash and assets based on fair market value at the date of gift to each recipient or donee each calendar year. Mary Doe, a widow, has three children. She may give $11,000 to each child each year. Collectively she may give $33,000 per year to the three children, and over a five year period this would amount to $165,000. These gifts are exempt from gift tax and no gift tax return is required if the amount does not exceed $11,000/year per donee.
The gifts do not have to be made to family members but can be made to anyone. Gifts, like an inheritance, are not subject to income tax. There is no income tax deduction for the donor and no income tax to report by the recipient.
The only exceptions for income tax are installment obligations (where the capital gains was legally deferred), United States savings bonds, retirement benefits (including IRA accounts), and single premium deferred annuities. The gift of these items will give rise to an income tax liability for the donor but not for the donee. A person should not make a gift of these items without discussing the tax implications with an accountant and/or attorney.
The $11,000 per year gift tax exemption is only allowed for gifts which meet the requirement of being a gift of what the Internal Revenue Code refers to as a "present interest." This means that the recipient receives the gift immediately without restriction, or it is restricted until the donee attains age 21. If a couple wishes to set up a trust for their children with each child receiving assets at age 30, the gifts will not be "present interest" gifts and will not qualify for the $11,000 exemption, unless the trust contains "Crummey" provisions.
In addition to the $11,000 per year exemption, an individual can also pay certain bills. These amounts are unlimited and do not impact or reduce the ability to give someone $11,000 per year.
First, education costs in terms of tuition can be paid in any amount provided that the payments are made directly to the educational institution. This does not include books, room and board, travel, or any payments other than tuition. Mary Doe discovers that her granddaughter has been accepted to Stanford University. Rather than give her son and daughter-in-law $22,000 per year to pay the girl's costs, Mary may pay the university directly for the tuition. She can also give her granddaughter up to $11,000 per year in gifts, and make gifts of $22,000 per year to her son and daughter-in-law.
Second, medical costs of virtually any type can be paid provided that payment is made directly to the provider of the medical service. Mary Doe pays her son and daughter-in-law's medical insurance of $1,000 per quarter by sending a check directly to the medical insurance company. Medical costs are defined as anything which would be deductible if the person had paid it as an itemized deduction on his or her income tax return. This includes doctor, hospital, medical insurance, prescription drugs, ambulance, and numerous other services. Again, this does not reduce the ability to give the person $11,000 per year.
A person may give any amount tax free to a spouse provided the spouse is a United States citizen. John Doe has $2,000,000 of separate property. He decides to make $1,000,000 community property, which means that he is giving one-half or $500,000 to his wife, who is a United States citizen. This is exempt from gift tax and no tax return is required for any amount given to a citizen spouse. If the spouse who is receiving the gift is not a United States citizen, no more than $114,000 per year can be given to the noncitizen spouse (2005). If a larger amount is given, it is subject to gift tax. If the donor is a United States citizen or permanent resident of the United States, then the gift tax exemptions are available to him or her. Only the citizenship of the spouse-donee is in question and presents a problem if he or she is not a citizen.
If a person makes a gift of over $11,000 in one year to one person or makes a gift of a "future interest," a gift tax return is required. If a gift tax return is due, it must be filed by April 15th of the year following the year of the gift. If John Doe gives $31,000 to his son on October 15, 1998, he must file a gift tax return by April 15, 1999. The only exception is if the donor dies after making the gift. Because any gift is includable in the estate at death for estate tax purposes, a gift tax return is necessary. Thus, a gift tax return must be filed within nine months of the date of death, or by the following April 15th, whichever is earlier. If John Dies makes a gift of $31,000 to his son on February 15th but dies on April 1st, the gift tax return would be due within nine months of the date of death, or by January 1st of the following year. If he dies on October 15th, the gift tax return would be due by the following April 15th, because that is earlier than nine months from the date of death. The gift tax return is Internal Revenue Service form 709. There is no California gift tax return.
The gift tax rates are the same as the estate tax rates. An individual is allowed a lifetime exemption of $1,000,000, so that in most cases no tax is due, only the requirements for the filing of the gift tax return. This is in addition to the annual $11,000/year/donee exemption.
John Doe gives his son $111,000. He is allowed a $11,000 exemption, so the taxable gift is $100,000. A gift tax return is due and the gift tax on $100,000 is $20,800. Because the unified tax credit, no tax is due. The return is filed and the gift reported.
For gift tax purposes, all prior taxable gifts are cumulated. If John Doe gave a second $111,000 to his son, he would be making another taxable gift of $100,000, but he has now given away a cumulative total of $200,000. Since the tax rates rise, the gift tax is figured on all of the taxable gifts (over $10,000 per donee per year). If the cumulative total exceeds $1,000,000, then a tax is due and must be paid with the return.
Since the government changed the system, the estate and gift tax rates have been combined in a "unified tax system" since late 1976. The advantage of gifting over $11,000 per year has been greatly diminished.
What happens if one spouse has a sizable amount of separate property and wishes to gift $22,000 of his separate property to each of his children? Since he is giving over $11,000 per donee in one year, a gift tax return is due. Federal law allows "gift splitting" with a spouse. This means that a $22,000 gift or a gift of any amount can be treated as if it came equally from husband and wife even though the gift came entirely from the separate property of one spouse. If the total is not more than $22,000 per donee no taxable gift would be made. To gift split, a special federal gift tax form, form 709, is filed for both spouses, indicating the gift is treated as coming equally from the two.
Formerly, if a person made a gift and died within three years, the value of the gift was included in full in the person's taxable estate. This was changed in 1976. Gifts are not put back into a person's estate unless the donor retained any "strings" on the gift, such as the right to revoke the gift, switch it to another person, or change it.
If a person makes a gift and pays a gift tax, and dies within three years, the tax paid is also put back into the estate. John Doe gives his son $1,261,000. He is allowed a $11,000 gift so that the taxable gift is $1,250,000. Since the gift is over $1,000,000, a gift tax is due. He pays a gift tax of $102,500. If he dies within three years, the value of the taxable gift ($1,250,000) and the value of the gift tax paid ($102,500) is put back into his estate--a total of $1,352,500. If he dies more than three years after making the gift only $1,250,000 is put back into his estate. In both cases, he gets a credit for the $102,500 gift tax paid on the estate tax return.
The value of making large gifts is that the value is determined at the time of the gift. If no "strings" are attached to the gift, that value is used at death. In the prior example, John Doe gave his son real estate with a value of $1,261,000. At his death five years later, the real estate was worth $1,500,000. It was put back into his estate at the gift tax value of $1,250,000, a savings of the tax on $250,000, the increase in value from the date of gift to the date of death.
It can be very beneficial to make gifts of assets which will appreciate from the date of gift to the date of death.
While the value of a gift for gift tax purposes is the fair market value as of the date of the gift, what is the income tax basis to the donee who receives the asset? Unfortunately, the basis is not the fair market value. The recipient of the gift steps into the donor's shoes for income tax purposes and does not get a stepped up basis at the time of the gift. John Doe gives his son $10,000 worth of stock which he purchased for $3,000 a number of years ago. If the stock was kept until John Doe died it would get a new value at death and if it was worth $10,000 at the father's death, then the son would have a basis for income tax purposes of $10,000. The $7,000 potential capital gains would be forgotten. However, this is not true with a gift. John Doe's son gets stock worth $10,000, but if he later sells it, he must use his father's cost basis of $3,000. For income tax purposes, assets do not get a new value at the time of a gift.
The rule is that the donee's cost basis is the donor's basis or the current fair market value, whichever is less. If the stock cost the father $12,000 but is worth $10,000 at the time of the gift, the cost basis for the donee is $10,000. If it cost $3,000 but is worth $10,000 at the time of gift, the cost basis to the donee is $3,000. The general rule is never to give away anything which has gone down in value. It is better to sell it and take a capital loss than to lose the loss by giving it away.
Gifts are an excellent way to save estate taxes at death. If the individual has over $1,500,000 to $3,500,000 of assets, at his or her death there will be an estate tax unless assets are left to charitable organizations. Gifts of up to $11,000 per person per year will not be put back in the donor's estate unless the donor retains some interest over the gifted property. If a full and completed gift is made, the assets will not be put back in the donor's estate, even if the gifts were made only hours before death.
Gifts of assets of more than $11,000 per year may be worthwhile if the assets are likely to appreciate between the date of gift and date of death. If so, the appreciation will be out of the donor's estate at death. Consideration must be given to income tax cost basis, because the gifted property will not receive a new or stepped up cost basis at death.
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