The IRS requires you to report all taxable gifts you make during the year and pay the appropriate tax. However, due to the generous exclusions and deductions available, the average taxpayer never files a gift tax return or pays gift tax. The intention of the federal government is to only impose a tax on wealthy individuals who dispose of their wealth by making high-value gifts.
Making tax-free gifts
Most of the gifts you make during the year are of no interest to the IRS. The agency is only interested in collecting revenue on taxable gifts. Generally, taxable gifts exclude:
- All tuition and medical payments you make for someone
- Anything you give to your spouse
- Contributions you make to some political organizations
- All other gifts that don't exceed the annual exclusion amount
The annual exclusion is the maximum value of gifts you can give to each person. For example, during the 2022 tax year, the law allows you to make an unlimited number of tax-free gifts as long as no one receives more than $16,000. Therefore, you can make hundreds of $16,000 gifts without paying a dollar in gift tax, as long as each recipient is a different person.
Using your unified credit
If you make a single gift during the year in excess of the annual exclusion amount, the tax law provides you with a unified credit to offset any gift tax you may owe. As you use the credit, the balance decreases.
To illustrate, suppose you make an $116,000 gift to your brother during 2022 for his birthday.
- You first use the annual exclusion to reduce the gift by $16,000 to $100,000.
- To avoid paying gift tax on the remaining $100,000, you can use an amount equal to the estate tax on $100,000 of your unified credit.
- Your unified credit balance then decreases and less is available to offset any future gifts you make during your lifetime.
Taxable portion of gifts
The amount of gift tax you may owe directly relates to the property’s value or the amount of cash you give. When you make a gift other than cash, the IRS requires you to assess the property’s fair market value.
The appropriate valuation method depends on the type of property; however, the value must always relate to the price a willing buyer would pay for the item in the open market. The IRS can impose significant penalties if you attempt to minimize your gift tax liability by purposely undervaluing the property.
Preparing a gift tax return
A requirement to file a gift tax return does not always mean you must pay gift tax. The IRS requires all taxpayers who make a gift in excess of the annual exclusion amount to file a return, even when eliminating all tax with the unified credit.
In the example above, the $116,000 gift you made to your brother in 2022 requires you to prepare Form 709, even though you don't owe any gift tax. The IRS requires you to document your use of the unified credit on your return. However, if your unified credit balance was zero, then the gift tax would be calculated on $100,000 of this gift.
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