Whether through a straight gift to a family member, an estate or to future generations there are a variety of ways to give money tax free.
The Gift That is Truly Win-Win
Gifting money to family members isn't just a nice thing to do for them -- it might result in a little tax relief, too. The transfer tax laws that govern gifts to family members are generally kind. In addition to money, gifts can include such things as cars, houses and stocks. These transfer laws are far-reaching, benefiting average citizens who want to gift a few hundred or a few thousand dollars as well as those who want to give a lot more. And many of these laws aren’t limited to gifts to relatives.
Options for Transferring Funds
The three taxes that govern transfers of funds to family members and others are gift taxes, for transfers made while the donor is still alive; estate taxes, for assets left behind after a death; and the generation-skipping trust tax, for gifts left to the generations following a donor’s children, notes Jerome Borison, an associate professor at the University of Denver’s Sturm College of Law, who teaches about taxes.
Gifts made by a living donor are by far the easiest to accomplish: These gifts require no more effort than writing a check and are tax-free as long as you stay within the limits established by the tax code, which for all but the mega-wealthy is relatively easy, Borison noted.
There are two limits for tax-free gifts: an annual ceiling of $13,000 to any one person, and a separate $5 million lifetime limit.
Compromise legislation passed in 2010 set the tax exemption limits and indexed them for inflation, but the legislation is due to expire at the end of 2012, so the limits could change.
Gifting generally is a way to avoid estate taxes for the donor and the recipient, according to Borison. That's because the tax code allows each American to give away up to $5 million -- through gifts, an estate or a combination of the two – tax-free in his lifetime. A married couple can give up to $10 million. Both amounts are adjusted for inflation under the 2010 legislation.
The individual’s limit is portable, according to Borison. That means if a husband or wife dies, that person’s remaining limit is transferred to the spouse, increasing the surviving spouse’s gifting limit to as high as $10 million.
For citizens of average means, the most important portion of the tax code allows taxpayers to give away up to $13,000 (adjusted for inflation) annually, tax-free, to as many people as the giver wants. For a married couple the limit is $26,000. These gifts are not part of the $5 million lifetime limit.
“Say I had 10 people I wanted to give money to,” Borison said, citing as an example three married children and their spouses and four grandchildren. “I can give $130,000 per year -- and my wife can, too -- and we have not even begun to eat into the $5 million limit.”
Theoretically, there is no limit to the amount you can give away under this part of tax law as long as it is limited each year to $13,000 (or twice that from a couple) per person, he said.
If a donor gives more than $13,000 to one recipient in a single year, the amount over $13,000 is deducted from the $5 million lifetime limit. Say you make a gift of $100,000 to a favorite relative or friend. You've exceeded the annual limit of $13,000 by $87,000, so that amount is subtracted from your $5 million lifetime limit, leaving you with $4,913,000. If you limit succeeding gifts to $13,000 per year per recipient, your lifetime limit won't diminish further.
Medical or Educational Gifts
A final tax category is gifts for educational and medical expenses. There is no limit on the amount you can give, and these gifts also don’t cut into the $5 million lifetime maximum.
Additionally, these tax-free gifts aren’t limited to family members. “If the kid down the street’s dad died and the family is struggling, you could pay for his college,” Borison said.
These gifts must be made directly to the institution involved, he added. To be tax-free, educational gifts must be made directly to the educational institution; medical gifts must be made to the hospital or to the medical provider.
The IRS instructions for Form 709, the gift tax return, say an educational gift can only go toward tuition. It can't be used for such items as books, supplies or room and board. Medical gifts can be used for the diagnosis, cure, treatment or prevention of disease and for transportation essential to medical care, but cannot be used for expenses covered by the recipient's insurance.
Downside to Gifting
There’s a downside for the recipient when the donor gifts an asset instead of leaving it behind in an estate. The basis, or original price of the asset in tax terms, can be substantially different.
Borison gave this example: A person bought property years previously for $10,000 that is now worth $100,000. His basis is $10,000, and his taxable gain is $90,000.
If he sold it, he would owe taxes -- probably capital gains taxes -- on the $90,000. But if, while he is alive, he makes a gift of it to one of his children, that child “basically steps into his shoes,” Borison says, keeping the same basis and gain. If that child were to immediately sell the property, she would owe taxes on the $90,000 gain, shifting the tax burden from father to daughter.
If he left the property in his estate, the $90,000 gain would disappear for tax purposes and the daughter’s basis would be $100,000, not $10,000. If she sold it, there would be no gain and so no tax consequence. If she kept it and it appreciated in value, the gain would start from her basis of $100,000, saving her $90,000 of taxable income.