Giving ‘Til it Hurts: The Annual Gift Tax Exclusion

IRS Gift ExclusionAfter years of playing the lotto, your seven lucky numbers finally hit it big, so congratulations on becoming the next big millionaire. Unfortunately, in between the screams of excitement and getting your picture taken with a large novelty check, you did not get around to changing your phone number. Now you have third cousins twice removed asking for a handout as repayment for that one time they babysat you or that long-lost uncle wanting you to invest in his biggest money making scheme yet. Tuna popsicles…a sure fire win. Not wishing to be rude but at the same time not looking to go back to the poor house, how much can you afford to hand out? Let the gift-giving commence!

What is considered a ‘gift’?

For tax purposes, a gift is when the value of the property transferred is greater than what is received in return for the transfer. Gifts can include transfers of cash or property, payments made to third parties on behalf of another, interest-free loans, below-market or “bargain” sales, transfers to an irrevocable trust, transfers with a retained life estate and, in some cases, adding a joint owner to property.

Are gifts subject to tax?

As a general rule, gifts are subject to gift tax whether it is a gift of cash or property that is transferred to another person. However, as with any good general rule, there are a few exceptions. One exception is the gift tax exclusion. Under this exception, if the total value of gifts made by a donor to any one individual in a taxable year is below a set amount, then the gift is not subject to gift tax. In 2012, the exclusion amount is $13,000 and in 2013 it will increase to $14,000.

Example: A taxpayer, for 2012, makes a gift of cash to three different individuals; no other gifts were made during the year. One gift was for $4,000, one for $6,000, and the last one for $13,000.  Even though the three gifts combined total $23,000, the taxpayer would not owe any gift taxes on the three gifts since no gift to any one individual was greater than $13,000. However, if that same taxpayer made an additional fourth gift of cash of $15,000, then gift taxes will be calculated based on the $2,000 that exceed the annual exclusion limit.

Does the gift exclusion always apply?

As great as the annual gift exclusion is, there is a limitation to the rule. The annual gift tax exclusion only applies to gifts of present interest. A gift of a present interest is one in which the person who received the gift has the unrestricted right to the immediate possession, use, and enjoyment of the property. One great example would be a Christmas check from a grandmother; the grandchild who receives the check has immediate possession of the money and may use it however they wish.

Gifts of a future interest in property do not get to use the annual gift exclusion. A gift of a future interest is where the person who receives the gift does not yet have the unrestricted right to the immediate possession, use and enjoyment of the property, but will have these rights at a later time.

Example of a future interest: John transfers cash to an irrevocable trust for the beneficial enjoyment of Rebecca, who is not his dependent. However, under the rules of the trust, Rebecca cannot begin to receive any money from the trust until she reaches the age of 18, eight years from now. The gift to Rebecca is a gift of a future interest because Rebecca will not be able to use the money until she reaches the age of 18.

In the example above, any amount John transfers to the trust on behalf of Rebecca will be subject to gift tax. The annual exclusion will not apply because Rebecca is receiving a future interest instead of a present interest in the gift.

So what does all this mean for you and your new wealth? You can be Ebenezer Scrooge at the end of A Christmas Carol, doling out gifts below the annual exclusion limit to as many family members as you want without fear of owing gift taxes. Who knows…maybe tuna popsicles will become as big as the hot dog.

More questions about the annual gift exclusion? Talk it out in the new H&R Block Community.

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About Jay Dunn - The Tax Institute at H&R Block

Jay Dunn is a licensed attorney and a tax researcher for The Tax Institute, specializing in retirement plans and estates & trusts.