Gift tax and estate tax are two halves of the same whole. The gift tax applies to all assets, including cash that an individual gives out while they are alive, while the estate tax is a tax levied on the assets that individual plans to give away once they die.
Despite the relative simplicity of these ideas, entire legal and financial fields revolve around the mechanics of these two taxes. To make things simpler to understand, here is a quick seven-point guide to gift tax, estate tax, and how they work off of each other.
Gift tax, despite its name, is not actually a tax that applies exclusively to items that are given explicitly as gifts. The definition of gift tax by the Internal Revenue Service (IRS) states that the tax applies to “the transfer of property by one individual to another while receiving nothing, or less than full value, in return.”
This means that any item that is given to another person for free could be considered gift tax. Not only that, but if you pay someone less than the item is worth, that may also count as a gift which you may have to pay the taxes on. Even casual gifts to a friend can count as gifts. Additionally, if you give someone a loan but don’t charge them any interest on repayment, that may also count as a gift.
An estate tax is a flat tax that is levied on an estate according to the fair market value of their assets. In plain terms, after you die, the court will take inventory of all your possessions, total up how much you owe to creditors, utilities, administration fees, or other financial obligations, pay out those obligations, and then total up the value of everything left over.
If the total value of your estate is above a certain threshold, $12.06 million in 2022, then the federal government will levy a varying flat tax on all the income over that limit. The highest federal estate tax rate for 2022 is 37%. Once the estate tax has been paid and the creditors have been satisfied, then the remaining assets of an estate are divided up according to the last will and testament of the deceased or according to state law if there is no will.
Though the IRS says that any time you give something to someone else for free or for less than it’s worth you’re giving a gift, they may not be able to tax it depending on who the recipient is. A number of carve-outs exist for people and entities to receive a gift and you don’t owe any taxes on it.
The most common groups that benefits from this exemption from gift tax are spouses and dependents. Your spouse is considered a joint owner of your property and therefore does not have to pay gift tax, while dependents need to be taken care of and therefore any assets you give to them are considered to be part of their care. That said, if you want to give assets to your child after they are past the age of dependency (age 19 or age 24 if the child is still a student), you may have to pay taxes on that gift.
Some other examples of situations where you may give away assets without receiving anything in return but are still exempt from gift tax include payments for tuition or education, political contributions, and charitable donations.
Though estate tax rates can reach as high as 37%, there are ways for you to avoid it, sometimes entirely. First, there is the estate tax exemption. That’s the $12.06 million threshold that the government requires your assets to exceed before they begin taxation. This threshold and taxation rate can vary as the tax code is adjusted over the years.
If your estate still exceeds the estate tax threshold, you can employ a number of deductions. The most effective deduction is the unlimited marital deduction. The marital deduction transfers assets from you to your spouse. This can be as many assets as you would like and none of it will count as part of your estate.
Additionally, you could employ a trust, either before your death or upon it, to stash assets for your intended heirs. Certain trusts remove legal title of assets from you completely and so those assets will not be counted as part of your estate’s valuation.
Gift tax is not as static as other parts of the tax code. The rate of taxation varies from as low as 18% to as high as 40%. This sliding scale allows taxation according to the size of the gift. However, there is also a gift tax exemption. Unlike the unlimited gift tax exemptions for certain entities, this annual gift tax exemption sets a limit on how much can be given away to a single person or entity per year.
In 2021, this annual gift tax exemption was $15,000. As the name suggests, every year this exemption is renewed and you are once again allowed to give assets to the same individual. There is, however, also a way to extend the reach of this gift tax exemption, If you are married, you and your spouse can combine your individual gift tax exemptions, allowing you to bestow up to $30,000 in gifts upon an individual.
An example of when you may want to do this is as follows. Suppose that your child is graduating medical school. As a show of how proud you and your spouse are, you buy them a new car. On average, a medical school graduate is around 28 years old. This places them outside of the range of a dependent. Similarly, a new car ise very likely to be outside the range of a single person’s annual gift tax exemption. However, by combining your annual gift tax exemption with your spouse, you will be able to pass on the new car tax free to your child.
Federal estate tax is not the only kind of tax levied against you after you pass. Depending on where you live, there may be state estate or inheritance taxes. If you live in Maryland, there will be both.
State estate taxes, like their federal equivalents, are taxes levied against your estate after you pass away. Unlike federal estate taxes, the state estate tax rates often slide along a scale and theur exemption thresholds are much much lower. Massachusetts, for example has an asset threshold as low as $1 million. State estate taxes may also have different exemptions that those that can be claimed for federal estate taxes, making it even more difficult to preserve your estate.
Inheritance taxes are another kind of last tax applied after you die. The difference for inheritance taxes is that they actually target your heirs. If someone inherits some assets from you, they may be on the hook for inheritance tax. If you do live in a state with either state estate taxes or state inheritance taxes, you should consider consulting with a trusts & estates attorney to ensure your legacy is protected at the federal and the state level.
Some gifts are too big for the exemption, even if spouses combine exemptions. For example, if you own your home and want to move to a retirement home, you may want to give your old house to your child. This will almost certainly exceed the annual gift tax allowance, but you don’t want to have to pay the steep gift tax rates.
In situations like these, after you use up your gift tax exemption, you can take the remainder out of your estate tax exemption. This workaround allows you to give the gift to your child tax free now, and have the remaining value come out of your estate. The IRS even predicts this possibility. As part of the full tallying of your estate, they will add up the value of taxable gifts, as in gifts that were not exempted, and subtract them from the federal estate tax exemption.
Before deducting from your estate exemption, it would be prudent to consult an experienced trusts & estates attorney. AAL has a number of experienced trusts & estates attorneys who can advise you on the best way to preserve your legacy and take full advantage of gift and estate tax exemptions.
*Disclaimer: Attorney At Law does not represent all lawyers in all states. There may be differences of opinion. It’s always advisable to consult with an attorney when in a legal situation.