There seems to be a great deal of confusion about the annual exclusion from gift taxes. Most of my clients with taxable estates have been told that they can give a certain amount (currently $13,000) per individual each year. Many view this as a hard rule. They believe that any gift over the annual exclusion will have catastrophic tax consequences.
This isn’t always the case. The vast majority of people need not be concerned with gifting more than $13,000 per year, especially under the current estate tax laws. Let’s take a quick look at the estate and gift tax rules involving the annual exclusion to see why.
What is the Annual Exclusion? A Quick Primer
The annual exclusion is an amount that the Internal Revenue Code allows you to give away to as many people that you wish, each year, without the amount being subject to gift tax or requiring the filing of a gift tax return. The annual exclusion is currently $13,000 but is indexed for inflation in $1,000 increments.
As a planning tool, the annual exclusion allows clients to reduce the value of their taxable estate. Every $13,000 that is gifted under the annual exclusion is $13,000 less that will be subject to estate tax at the client’s death.
For example, assume that a husband and wife have three grown children and three grandchildren. By giving the annual exclusion amount to each child and grandchild, husband and wife could make annual exclusion gifts of $78,000 per year ($13,000 X 6 beneficiaries). The same husband and wife could also make annual exclusion gifts to the spouses of their children, allowing them to gift another $39,000 per year ($117,000 total). That’s $117,000 more that the client can leave to the next generation free of gift and estate taxes.
The annual exclusion can also be leveraged to give away more than $13,000 of actual economic value to each recipient free of estate or gift taxes. For example, annual exclusion gifts are commonly used in conjunction with family limited partnerships. The children are given limited partnership interests that already reflect a discounted value. Over time, the aggregate amount shifted to the children includes far more than the sum of each year’s $13,000 annual exclusion.
Why Most Clients Can Ignore the Annual Exclusion Amount
As mentioned earlier, many people are vaguely aware of these rules and assume that they are absolutely prohibited from gifting more than $13,000 per year. But this isn’t the case. To understand why, you need to understand what happens if the gift exceeds $13,000.
Say that Joel, an unmarried man, has an estate worth $1 million. In 2012, Joel decides to give his $100,000 vacation home to his daughter Sally. This gift clearly exceeds Joel’s $13,000 annual exclusion. Does that mean that Joel or Sally will need to pay taxes on the transfer?
The answer is “no.” Each person has a certain amount (called the applicable exclusion amount) that he or she can give away during their lifetime and at death without being subject to estate or gift taxes. That amount is currently $5 million. That means that Joel can give an aggregate of $5 million away during his lifetime or at his death without worrying about estate taxes. Since Joel’s estate is only worth $1 million he doesn’t need to worry about being subject to estate or gift tax on any lifetime transfers. The gift of the vacation home to Sally will not be subject to gift taxes.
Gifts in excess of the annual exclusion only reduce the overall applicable exclusion amount. Under current law, each gift in excess of $13,000 will chip away at the $5 million that a person could otherwise transfer free of estate and gift taxes.
In Joel’s case, he gave away $87,000 more than the annual exclusion amount ($100,000 value of home less $13,000 annual exclusion amount). This $87,000 will reduce his applicable exclusion amount of $5 million to $4,913,000. Since Joel’s estate is only worth $1 million, his remaining $4,913,000 exemption will easily cover the value of his estate at death. No estate or gift taxes will be paid on the transfer of the home to Sally.
That isn’t to say that the transfer of the home has no tax consequences, though. There are two primary effects of the transfer of the home:
- Because the IRS needs to be able to track the reduction of the applicable exclusion amount, Joel will need to file a gift tax return to report the value of the transfer. This is purely a reporting issue. No estate or gift taxes will need to be paid.
- Sally will take Joel’s basis in the vacation home. This means that any appreciation in the home at the time of the transfer will follow the home into Sally’s hands. When Sally sells the home, she will pay taxes on any appreciation that accrued during her lifetime and any appreciation that accrued while Joel owned the home. If Joel held the property until his death, any appreciation that accrued during Joel’s lifetime would be wiped out.
These two rules (the need to file a gift tax return for gifts in excess of the annual exclusion and the transferred basis rule) are the only two that most clients need to know. Because the value of most people’s estates doesn’t exceed the applicable exclusion amount (currently $5 million per person, $10 million per married couple), most people don’t need to worry about paying gift taxes for gifts in excess of the annual exclusion amount (currently $13,000).