I recently had the pleasure of speaking with Kate Ashford, a freelance journalist who occasionally writes “The Help Desk” column for CNNMoney online.  Her question was a common one: how are gifts taxed?  There is a lot of confusion on how gifts are taxed, and to whom they are taxed.  Here’s a few tips to sort out taxes relating to gifts:

What type of tax are you talking about?

There are different types of taxes that could potentially apply to gifts, namely, income tax and gift tax. 

Income Taxation of Gifts.

As a general rule, gifts you receive from others are not included in your income tax.  In other words, any amount received by you as a gift is completely tax-free (same rule applies to inheritances too).  Of course, this assumes that the amount received is actually a bona-fide gift.  You can’t try to fool the IRS by passing off a large bonus from your work as a gift.  But if you honestly receive a gift from a family member, for example, then there’s no income tax to you.  It doesn’t matter if its $1.00 or $1,000,000, it’s a tax-free gift to the recipient.

Don’t confuse gifts with things such as gambling winnings, lottery prizes, game-show loot, or receiving the HGTV Dream Home (if you are so lucky)—all of those cash and prizes are subject to income tax when, or rather if, you receive them.

Gift Tax.

Gifts are subject, however, to our Gift and Estate Tax rules, which obligates the grantor (that is the person GIVING the gift) to pay tax on all gifts made.  Read that again: the person making the gift is obligated to pay the tax—not the person receiving it.  Sounds ridiculous?  Maybe.  But that’s our gift tax system; if you’re going to be generous by giving a gift, then you may have to give an extra gift to Uncle Sam.

To begin with, you should also think that all gifts are taxable.  There are a few exceptions, but if you don’t fit within one of the exceptions, then prepare to be generous to the IRS.

The Exceptions to Gift Tax.

Annual Gift Tax Exclusion.  Every person has the right to gift up to $13,000, per person, per year.  These annual exclusion gifts do not have to be reported to the IRS.  The “per person, per year” requirement means that a single person can make multiple gifts to different people each year.  So a grandfather could gift up to $13,000 to each of his children, and each of his grandchildren and not have to report the gifts, provided that no one person received more than $13,000 in a given year.

Many people remember the annual exclusion gifts as being the annual $10,000 gifts.  That is the prior gift tax exclusion amount before they were indexed for inflation.  The annual gift amount is now $13,000.

Marital Deduction.  Spouses can gift each other an unlimited amount of gifts and pay no gift tax whatsoever.  The only requirement is that the couple must be legally married.  Sounds simple, but it can be tricky at times. 

For example, California does NOT recognize common-law marriage, unless such marriage is established in another State that does recognize common-law marriage (such as Texas).  Also, California does not recognize same-sex marriage (remember Proposition 8?).  California does allow same-sex partners to register and thereby receive many of the same benefits and obligations as married couples, but not the status of legal marriage. 

Gift Tax Exclusion.  Under our current Estate and Gift Tax laws, every individual is allowed an exclusion from gift and estate tax equal to $5,000,000.  This means that you can give up to $5,000,000 away and not have to pay a gift tax on that transfer.  However, any amount of exclusion you use during your lifetime by making gifts, reduces what you have left for your estate.  So if you gift $2,000,000 during your lifetime, you pay no gift tax, but your Estate Tax exclusion is reduced from $5,000,000 to $3,000,000 to account for the $2,000,000 of exclusion you used while alive.

Gifts in any single year to a single person that exceed $13,000 must be reported to the IRS using a Gift Tax Return (Form 709) even though no tax will be due on the return.  This reporting requirement allows the IRS to track gifts made over your lifetime to determine when, and if, you exceed you tax-free limit.

Charitable Gifts.  As you would expect, gifts made to charity, in any amount, are free of gift tax.  Luckily the IRS is not so callous as to require a generous donor to pay tax on gifts to charity. 

But beware, the charity must be recognized as a valid charity by the IRS under Internal Revenue Code Section 501(c)(3).  Always ask to see proof of a charity’s determination letter before making any large gifts to charity, and then confirm the charity’s status with the IRS because sometimes charitable status can be revoked by the IRS.

Tax Law Changes.

Tax laws these days are very fickle things.  The current set of laws for Estate and Gift Tax are set to expire at the end of 2012, meaning that a whole new set of rules will be put in place.  We have no way of knowing if the rules will be better or worse than what we have now.  So you have to keep an eye out for future developments.

The bottom line: no good dead goes unpunished.  Giving ‘till it hurts really can hurt if you don’t plan out your gifting ahead of time.

  • Christa

    So my parents own a lot of real estate and are trying to figure out the best way to give the houses to me and my siblings. What would be the best way for them to do this, with minimal costs incurred?

    • davidsonkeitha

      A living trust is the best way to do this. In California, you can now do beneficiary deeds, but they are limited to only a personal residence–they cannot be used for commercial properties or apartments over 4 units.

      But even with beneficiary deeds being an option, a living trust is still the best. A trust allows you to plan for the future, but still own the property today. The living trust costs a bit more, but it saves a lot more money down the road if you do no planning. So the best way forward with minimal costs incurred would be to have a trust prepared.