Gift Taxes - The Basics

“Never look a gift horse in the mouth” is a famous adage that warns us not to ask questions when receiving a gift—just be grateful!  However, gift giving should be executed strategically to make the most of a contribution and reduce tax liabilities.  While there are numerous gifting techniques that alleviate taxes, there are also numerous contingencies regarding the size, frequency, and purpose of the gift.  The following explanation of the gift tax laws was excerpted from IRS Publication 950, which has not yet been updated with 2005 figures. See Editor's notes for updates below.

The gift tax applies to the transfer by gift of any property. You make a gift if you give property (including money), or the use of or income from property, without expecting to receive something of at least equal value in return. If you sell something at less than its full value or if you make an interest-free or reduced interest loan, you may be making a gift.

The general rule is that any gift is a taxable gift. However, there are many exceptions to this rule.

Generally, the following gifts are not taxable gifts:

·         Gifts that are not more than the annual exclusion for the calendar year,

·         Tuition or medical expenses you pay directly to a medical or educational institution for someone,

·         Gifts to your spouse,

·         Gifts to a political organization for its use, and

·         Gifts to charities.

Annual exclusion
A separate annual exclusion applies to each person to whom you make a gift. For 2004, the annual exclusion is $11,000. (Editor's note: the annual exclusion for 2005 ia also $11,000.) Therefore, you generally can give up to $11,000 each to any number of people in 2004 and none of the gifts will be taxable. 

If you are married, both you and your spouse can separately give up to $11,000 to the same person in 2004 without making a taxable gift. If one of you gives more than $11,000 to a person in 2004 ...  

Example 1.    In 2004, you give your niece a cash gift of $8,000. It is your only gift to her this year. The gift is not a taxable gift because it is not more than the $11,000 annual exclusion.

Example 2.    You pay the $15,000 college tuition of your friend. Because the payment qualifies for the educational exclusion, the gift is not a taxable gift.

Example 3.    In 2004, you give $25,000 to your 25-year-old daughter. The first $11,000 of your gift is not subject to the gift tax because of the annual exclusion. The remaining $14,000 is a taxable gift.  You may not have to pay the gift tax on the remaining $14,000. However, you do have to file a gift tax return.

Gift Splitting
If you or your spouse make a gift to a third party, the gift can be considered as made one-half by you and one-half by your spouse. This is known as gift splitting. Both of you must consent (agree) to split the gift. If you do, you each can take the annual exclusion for your part of the gift.

In 2004, gift splitting allows married couples to give up to $22,000 to a person without making a taxable gift. (Editor's note: In 2005, the same figures apply.)

If you split a gift you made, you must file a gift tax return to show that you and your spouse agree to use gift splitting. You must file a Form 709 even if half of the split gift is less than the annual exclusion.

Example.    Harold and his wife, Helen, agree to split the gifts that they made during 2004. Harold gives his nephew, George, $21,000, and Helen gives her niece, Gina, $18,000. Although each gift is more than the annual exclusion ($11,000), by gift splitting they can make these gifts without making a taxable gift.

Harold's gift to George is treated as one-half ($10,500) from Harold and one-half ($10,500) from Helen. Helen's gift to Gina is also treated as one-half ($9,000) from Helen and one-half ($9,000) from Harold. In each case, because one-half of the split gift is not more than the annual exclusion, it is not a taxable gift. However, each of them must file a gift tax return.

Applying the Unified Credit to Gift Tax
After you determine which of your gifts are taxable, you figure the amount of gift tax on the total taxable gifts and apply your unified credit for the year.  

Example.    In 2004, you give your niece, Mary, a cash gift of $8,000. It is your only gift to her this year. You pay the $15,000 college tuition of your friend, David. You give your 25-year-old daughter, Lisa, $25,000. You also give your 27-year-old son, Ken, $25,000. Before 2004, you had never given a taxable gift. You apply the exceptions to the gift tax and the unified credit as follows:

1.  Apply the educational exclusion. Payment of tuition expenses is not subject to the gift tax. Therefore, the gift to David is not a taxable gift.

2.  Apply the annual exclusion. The first $11,000 you give someone during 2004 is not a taxable gift. Therefore, your $8,000 gift to Mary, the first $11,000 of your gift to Lisa, and the first $11,000 of your gift to Ken are not taxable gifts.

3.  Apply the unified credit. The gift tax on $28,000 ($14,000 remaining from your gift to Lisa plus $14,000 remaining from your gift to Ken) is $5,560. You subtract the $5,560 from your unified credit of $345,800 for 2004. The unified credit that you can use against the gift tax in a later year is $340,240.

You do not have to pay any gift tax for 2004. However, you do have to file Form 709.