Who doesn`t love receiving gifts? You may argue that it’s better to gift than to receive, but did you know that gifting assets to others can also be valuable for your estate planning needs? It’s important to understand what constitutes a gift, according to the IRS, and what that gift could cost you in taxes if you don’t plan ahead.

 What Constitutes a Taxable Gift?

The Internal Revenue Service (IRS) defines a gift as “any transfer to an individual, either directly or indirectly, where full consideration is not received in return.” So, if you give someone property, a car, investments, or write someone a check (other than your spouse or dependent), without being compensated for the value of what you’ve given, you have legally made a gift. It could also mean a loan you have given with zero interest or forgiving a large debt that someone owed you. Nonetheless, the government does give you some wiggle room.

The general rule is that any gift is a taxable gift. However, this rule has many exceptions, as we’ll explain in detail here.

Avoid Penalty with the Gift Tax Exclusion

There are a few ways to make a tax-free gift. The first and easiest way is the annual gift tax exclusion. The gift tax exclusion limits the total value you can gift to an individual in a year. The annual exclusion is $16,000 per person in 2022 ($17,000 in 2023). That means you can gift $16,000 to any individual throughout the year, either all at once or through a series of transactions. Or, if you are married, each of you can gift $16,000 to that individual for a gift of $32,000. And you can gift it to as many people as you like. So, if you gift the maximum of $16,000 to 10 different people, you will be gifting $160,000 in one year. Or, if you are married, $320,000. These gifts won’t count against your lifetime gift tax exclusion, and the recipient won’t owe any taxes on the gift.

Gift Tax Exclusion vs Gift Tax Exemption

While the gift tax exclusion limits individual gifting in a year, the lifetime gift tax exemption is the amount of money or assets the government permits you to give away over the course of your lifetime without paying the federal gift tax. The lifetime gift tax exemption is adjusted for inflation every year, and it’s allowed for both spouses in a married couple.

In 2022, you can use the lifetime exemption amount of $12.06 million before you start to owe gift tax. Your spouse is entitled to a $12.06 million exclusion if you're married. Any gifts you make to an individual, which exceed the annual exclusion, will count against your lifetime exemption. For example, if you gifted an individual $76,000, your lifetime exemption would be reduced from $12.06 million to $12 million. The exclusion will increase to $12.92 million in 2023. Unfortunately, as of January 1, 2026, the lifetime exclusion is expected to drop to approximately $6.4 million per individual. This is when the 2017 tax law expires. In 2021, Congress considered accelerating the decrease, but it was voted down. Also, with general elections in 2022 and 2024, changes in Congress could mean changes to the exclusion amount could happen sooner.

Not All Gifts are Taxable

Some gifts are not considered “taxable gifts” in the eyes of the IRS and, therefore, do not count as part of the lifetime exclusion.  Some of these tax-free gifts include:

• Charitable gift – it must be to a qualified charity.
• Gift to a spouse – The “unlimited marital deduction covers spouses.” They must be a U.S. citizen. Same-sex spouses are included as long as they are legally married, not registered domestic partners or civil union partners. Foreign spouses are subject to an annual limit of $164,000 in 2022 or $175,000 in 2023.
• Tuition – Payment must be made to the educational institution for tuition only. Books, supplies, and living expenses do not qualify.
• Medical expenses – Payment must be paid directly to the person providing the care, the institution providing the medical care, or the company providing the medical insurance. Qualified expenses include diagnosis/treatment of disease, procedures affecting a structure or function of the body, transportation, or medical insurance, including long-term care insurance.
• Gift to a political organization for its use. You can give to a few tax-exempt organizations, as well. These include civic leagues, horticultural and agricultural organizations, and labor organizations, but not labor unions.

If you make a taxable gift (more than the annual exclusion), you must file Form 709, which is the U.S. Gift and (Generation-Skipping Transfer) tax return. This return is due at the tax filing deadline, usually April 15th, unless this day falls on a weekend. You can mail the form in with your personal tax return. If you extend your personal tax return, your gift tax return deadline is also extended to October 15th. You must file the gift tax return even if you do not owe any gift tax to track how much of your lifetime exemption you have used. And, if you are married, you must file separate gift tax returns to show if you split the gift with your spouse. This form currently cannot be filed electronically.

Gifting in Your Financial Planning

So, when does it makes sense to start gifting your assets? The answer is that it depends. Mainly, it depends on what type of asset it is, whether you may need those assets in the future, and to whom you are making gifts. Virtually anything you own can be gifted to others. The easiest and most recommended asset to gift is cash.

Gifting Property

It makes sense to gift assets that are expected to appreciate, as property often does. However, if the property has a cost basis higher than its fair market value, you should not gift it. Instead, sell the property, realize the loss for tax purposes, and make a gift of the proceeds. Do not gift property that you will continue to use, such as your residence, especially if you qualify for the Section 121 housing exclusion ($250,000 for single filers and $500,000 for married couples). These are just a few examples of assets you should and shouldn’t gift. Consult your tax consultant and financial advisor if you question gifting assets other than cash.

When to Make Gifts

The next question is if you should gift assets now or if you will need them throughout your lifetime. Unknown expenses in retirement, such as long-term care and health care can alter any financial plan. Once it is known that there are plenty of assets to cover any healthcare situation, then you can determine what can be safely given away. In addition, for those who have acquired enough wealth to surpass the current $12.06 million exemption, it may make sense to gift as much of that as possible now, compared to down the road. Gifting it now would lock in the current exemption before it is cut in half in 2026. The best way to answer this question is to have a solid financial plan in place to compare your assets, liabilities, income, and expenses.

Another big concern with gifting is who will be on the receiving side of the gift. Most often, parents want to reduce their estate and gift to their adult children. If the gift is not above the annual exclusion, no tax is paid, and the beneficiary uses the gift any way they choose. Some parents or grandparents desire to gift to children who have not reached adulthood. One option would be to gift the assets to an irrevocable trust and make the child the beneficiary. This allows you to determine how the assets will be invested and distributed, over time, without worrying about Kiddie Tax laws. You can also set up a UTMA (Uniform Transfer to Minors Act) or UGMA (Uniform Gift to Minors Act) account to hold the assets for your child. The parent can be the account's custodian until the age of 18 or 21, depending on the state. Gifts can be made to 529 plans, with a special gift rule. You can make a lump-sum contribution in a single year, equal to five years of contributions. For example, you can contribute $80,000 in 2022 and spread the gift over the next five years. The catch is that you cannot make any additional gifts over that timeframe. If you do, it will count against your lifetime exemption.

Gifting In Advance of Long-Term Care and the Medicaid Look-Back

A final concern regarding gifting is Medicaid's look-back period and your estate. If you, or your spouse, go into a long-term care facility or nursing home and apply for Medicaid, there is a penalty imposed on recent gifts, specifically, gifts made within the last five years or 60 months. The penalty period is determined by taking the gift amount divided by the average monthly cost of nursing home care. An example would be if you gifted $10,000 to your grandchildren three years ago. The monthly cost of the nursing home is $5,000. You would have to cover two months of payments on your own ($10,000 / $5,000). The 3-year rule states that assets gifted within three years of a person's death must be included in the value of their estate for tax purposes. Gifts are exempt from the 3-year rule if you did not have to file a gift tax return to claim the annual exclusion or did not have to pay the tax on the gift at the time you made it. This does not include life insurance policies. In other words, if a gift of $26,000 is made within three years of the decedent's death, only $10,000 of that gift, the amount above the exclusion, will be included in the gross estate. The 3-year rule would still apply in the case of a policy gifted to an irrevocable life insurance trust (ILIT). A few ways around this would be to sell the policy to the ILIT, or initially form the trust and the trust purchase the policy.

Estate Planning with Gifting Constantly Evolves

An essential part of any estate plan is knowing how to gift assets in the most tax-efficient way possible, whom to gift them to, and when it makes the most sense. The rules and numbers around the annual gift tax and lifetime exclusion are always changing. While we cannot change the tax code, we can plan around it. Working with an estate planning attorney and a financial advisor can help you weigh your options and find the optimal strategy to transfer wealth while minimizing taxes.

This article is meant to give a brief overview of tax-free gifts and does not constitute tax planning or estate planning advice. Consult with a tax or legal professional for more information.

Author: Chris P. Wieder, CFP® | Financial Advisor | Allegheny Financial Group (Allegheny Financial Group - Chris P. Wieder, CFP®)

Allegheny Financial Group is a Registered Investment Advisor. Securities offered through Allegheny Investments, LTD, a registered broker/dealer. Member FINRA/SIPC.

Sources:

• Frequently Asked Questions on Gift Taxes | Internal Revenue Service (irs.gov)
• The Gift Tax Made Simple - TurboTax Tax Tips & Videos (intuit.com)
• IRS Announces Estate And Gift Tax Exemption Amounts For 2023 (forbes.com)
• About Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return | Internal Revenue Service (irs.gov)
• UTMA (Uniform Transfer to Minors Act)
• UGMA (Uniform Gift to Minors Act)