Simplifying the gifting process

gift-splittingDespite its perceived simplicity, gifting remains one of the most misunderstood financial concepts. Confusion in this area has led to under-utilization and potentially higher taxes owed by taxpayers each year.  From misconceptions about potential taxes owed by the donor or recipient to inaccurate information regarding the maximum gift allowable, taxpayers continue to get tripped up on how best to leverage this opportunity.  Gaining a clear understanding of the mechanics of gifting may help reduce both future estate taxes and current income taxes while also benefiting the recipient.

So why are so many taxpayers unsure of how to leverage this tool? For starters, the most common misconception is centered on how much you can give per year. The annual gift exclusion represents the amount that an individual can give to another person each year without having to file a gift tax return or impact their applicable credit. (more to follow on the applicable credit) For 2016, the annual gift exclusion is $14,000 per person.

Married couples can combine their gifts (known as gift splitting) which would allow for up to $28,000 to be gifted to each recipient. Gift splitting requires a gift tax return be filed to confirm that both spouses agreed to split the gift.

So what is an applicable credit and why is it so important when gifting? The applicable credit represents the total amount that you can transfer at death or during your life without paying federal estate or gift taxes.  For 2016, the applicable credit is $5.45 million dollars.  This means that you may be able to gift up to $5.45 million dollars in one year without any gift taxes being owed if you so choose.  If you gift or pass assets at death greater than $5.45 (individual) you may be subject to gift and estate taxes respectively. While you must file a gift tax return when gifting amounts greater than $14,000, you may not owe any taxes if your cumulative lifetime gifts are less than $5.45 million dollars.  Keep in mind that only the gift giver is responsible for any taxable gifts in excess of $5.45 million.

Unfortunately, many taxpayers assume they are limited to $14,000 per year when in actuality, they could gift significantly more. This presents an attractive approach to reducing estate taxes.

Why gift?

Gifting is a great way to remove assets from your estate before you pass away – especially for assets that are expected to appreciate significantly or you are near maximum thresholds. Even if your estate is below the $5.45 threshold, gifting can help minimize taxes – especially if you pass away in a state that imposes its own estate and inheritance taxes. Remember, estate taxes will vary from state to state.

Gifting can also provide an attractive means of transferring assets to family members who might be in a lower tax bracket. Additionally, many taxpayers prefer to gift before they pass away as it allows them to watch their family benefit from the gift today.

Front load gifts for college planning

Special rules allow for significant lump sum contributions to 529 education plans.   For 2016, up to $70,000 ($140,000 for married couples) can be contributed at one time to a 529 plan through the acceleration of five years’ worth of contributions as gifts. This can be a powerful way to make a huge dent in future college costs for children or grandchildren.

Be careful what you gift

Gifting highly appreciated assets may not be an ideal strategy. Keep in mind that the cost basis of the asset gifted is generally transferred to the recipient.  This means that the recipient may be stuck paying significant capital gains taxes when they turn around and sell the asset in the future.  Alternatively, assets that are passed at death receive a step-up in cost basis to the value on the date of death – essentially extinguishing any gains and their associated taxes.

Look-back provisions

It is also important to be aware that some states may have claw-back provisions that add gifts back into the estate when calculating state level estate taxes if they are deemed “in contemplation of death”.  For example, NJ requires that gifts made within three years be added back to the estate.  Remember, Medicaid has a 60 month look-back period for gifts as well.

It may also be possible to make tax-exempt gifts where the amount gifted does not count against the lifetime exemption. These circumstances include charitable gifts (tax deductions may apply), gifts to your spouse, payments for medical care and education expenses with all providing a great opportunity for additional gifting.  Keep in mind that payments must be made directly to the medical service provider or educational institution and room & board and books are not covered.

While gifting misconceptions often cause many taxpayers to overlook opportunities to reduce taxes, it is critical to understand all of the implications associated with gifting prior to making any moves. This includes confirming that you will continue to have sufficient resources to meet your personal financial planning needs in the future. Review IRS Publication 950 - Introduction to Estate and Gift Taxes and before beginning any gifting strategy, consider speaking to your tax, legal and financial adviser to determine the most appropriate strategy for your unique situation.