Few things bring as much joy as giving a meaningful gift to someone you love.
Whether it’s a holiday gift, birthday gift, or simply just a surprise to show someone you care, it’s a great feeling to watch someone get excited about something you’ve given them.
As a parent, grandparent, or another loved one, you might find yourself giving large gifts throughout the year, especially if you have children and other young people in your life. Many people find themselves wondering whether these generous gifts are tax-deductible.
It’s important to understand the tax laws when making large gifts. So, in this article, we’ll cover exactly which types of gifts are tax-deductible and which you might have to pay taxes on.
Are Gifts Tax Deductible?
When figuring out whether a gift is tax-deductible, it depends on who the gift recipient is. If you’re giving money or other items to loved ones, then they aren’t tax-deductible. But those to certain organizations may be.
Gifts to charitable organizations
The IRS allows taxpayers to deduct gifts (known in this case as contributions) of either money or property to a qualified charitable organization.
Depending on your tax situation, it may or may not be in your best interest to deduct these contributions when you file your taxes. Only those who itemize their deductions can deduct a charitable gift. For most people, claiming the charitable deduction just doesn’t make sense, as the amount gifted is less than you get by using the standard deduction.
The good news is that even if your charitable contribution isn't a tax-deductible gift, there won’t be a negative tax implication, as there could be with gifts to individuals.
Gifts to individuals
Unlike gifts to charitable giving, gifts you give to individuals or non-qualified organizations aren't eligible for a tax deduction.
In fact, not only can you not deduct those gifts, but you may have to pay taxes on them.
How Does the Gift Tax Work?
The federal gift tax applies to all transfers of gifts from one individual to another.
According to the IRS, a gift is any transfer of property — it could be money, financial assets, or physical property — where the giver doesn’t receive full payment in return.
Before you worry about whether you’ve been skipping out on your taxes all these years, there are some notable exceptions that result in very few people being liable for gift taxes.
Let’s go through them:
The IRS gives each person an annual exclusion, which is the amount they can give to another person in a tax year without having to file a gift tax return. As of 2021, the annual exclusion is $15,000.
The annual exclusion applies to each recipient. Suppose you wanted to give a large amount of money to each of your grandchildren in a particular year. You could gift up to $15,000 per recipient before filing a gift tax return.
There is also a separate annual exclusion for each gift-giver, even when it’s a married couple. So you as an individual can give up to $15,000 before you must file a gift tax return. And you and your spouse can give a collective $30,000 before you file gift tax returns.
As a taxpayer, it’s your responsibility to keep track of your gifts throughout the year. If you gift more than $15,000 to another person, you must file a gift tax return, even if you spread it out across multiple gifts.
Even if you exceed your $15,000 annual exclusion and have to file a gift tax return, the chances are slim that you’ll actually pay the gift tax.
In addition to the annual exclusion, the IRS also grants each person a lifetime gift tax exclusion.
As of 2021, the lifetime exclusion is $11.7M. Each gift above and beyond your annual exclusion will subtract from your available lifetime exclusion. It’s not until you’ve reached your lifetime exclusion of $11.7M that you’ll start paying the gift tax.
It’s important to note that the current lifetime exclusion amount was the result of a temporary policy change in the 2017 Tax Cut and Jobs Act.
After the change sunsets in 2025, the lifetime exclusion will return to its previous level of $5.25M.
It’s also important to note that the lifetime exclusion applies to both the gift tax and the estate tax. When you die, the first $11.7M of your estate can pass to your heirs tax-free. But if the estate exceeds that amount, you’ll pay the estate tax.
If you’ve used up part of your lifetime exclusion on gifts during your life, then more of your estate may be taxable.
What Are Some Examples of Taxable Gifts?
A gift could be anything of value that one person transfers to another. Gifts can be money, physical property, financial assets, etc. Let’s look at some specific examples of what a gift is for tax purposes.
Suppose that you gift your niece or nephew an envelope with cash for their birthday. According to the IRS, that cash is a gift and could be subject to gift taxes.
It’s unlikely that you’re handing over an envelope with $15,000 in cash. But remember that your annual exclusion applies to all gifts to another person in an entire calendar year. As the gift donee or giver, you have to keep track of your gifts.
Let’s say you give that niece or nephew several envelopes of cash throughout the year, each of which has several thousand dollars in it. In that case, you may end up having to file a gift tax return.
Physical gifts could also be subject to the gift tax. The tax applies to the market value of any physical property you transfer to another person.
Suppose that your teen just turned 16 and you buy them a new car. If the value of the car exceeds $15,000, you would have to file a gift tax return. You will also have to file a gift tax return if the value of the car combined with any other gifts throughout the year adds up to more than $15,000.
It’s worth noting that in this particular case, the gift tax would only apply if you transfer legal ownership of the car to your child. If you buy the car and maintain ownership but allow your child to use the car, you don’t have to worry about the gift tax.
The gift tax also applies to gifts that aren’t quite as tangible as cash or a car. For example, gifting stocks, bonds, or other securities to a loved one could also result in having to pay the gift tax.
Gifts for less than fair market value
Something could be a gift, even if the recipient pays you for it. According to the IRS, a property transfer is a gift if less than full value is received in return.
Let’s go back to that example of you gifting your child a car.
Imagine that instead of giving them the car, you sold it to them at a discounted rate. If the car is worth $30,000 and you sell it to them for $10,000, you’ve given them a gift worth $20,000. The difference between the fair market value of the gift and the amount they paid makes this a taxable gift.
How the Gift Tax Calculation Works: An Example
Suppose your niece is getting married, and you’ve decided to give her a large sum of cash as a wedding gift. You’ve been saving this money especially for her and feel that now is the perfect time to give it.
Let’s say your gift is $20,000, which is $5,000 above your annual exclusion.
You’ll have to file a gift tax return, and the $5,000 above your annual exclusion will be subtracted from your lifetime exclusion. The good news is that you still have $11,695,000 left.
But let’s say that you’ve already gifted millions of dollars throughout your lifetime. In fact, you’ve used up your entire lifetime exclusion.
Even once you reach your lifetime exclusion, you still get your annual exclusion each year.
In the case of your niece’s wedding gift, the first $15,000 of your gift would be tax-exempt. Then you’d pay gift taxes on the $5,000 above your annual exclusion.
How to Avoid Paying Taxes on Gifts
Most people will never have to worry about the gift tax. But if it is a concern for you, you can take some simple steps to avoid paying this tax in the future.
Give less than your exclusions
The simplest way to avoid paying gift taxes is to give less than your annual and lifetime exclusions. With some strategic gifting, even high net worth individuals can avoid gift taxes.
First, track how much you’re gifting throughout the year to make sure you don’t give more than $15,000 to another individual.
If you have a high net worth and expect to give more than $11.7M, gifting consistently throughout your lifetime can help avoid going over your annual exclusion in any one year.
For example, let’s say you have $12M you want to pass onto your children during your lifetime. A gift that large at one time would put you above your lifetime exclusion, and you’d have to pay gift taxes. But if you spread the gift out over many years, you could avoid the tax altogether.
Suppose you have five children. Over a period of 25 years, you could gift $15,000 per year to each child without having to file a gift tax return.
At that point, you’d have gifted $1,875,000. The amount left is less than your exclusion, meaning you could gift it in one lump sum at the end of your life without paying gift taxes on it.
Gift tax-exempt gifts
While gifts to loved ones may not be tax-deductible, there are some situations where they’re tax-exempt. Examples of tax-exempt gifts include:
- Tuition or medical expenses paid directly to an institution. Suppose you wanted to pay for your grandchild’s college tuition but didn’t want to file a gift tax return.
Rather than giving the money to your grandchild, you can send it directly to the university, and it doesn’t count as a taxable gift. The same rule applies to medical bills when you make the payment directly to the hospital or doctor’s office.
- Gifts to your spouse. The IRS allows married couples to transfer unlimited gifts to one another without having to pay the gift tax.
- Gifts to political organizations. If you donate money to a political organization, you won’t have to pay gift taxes. If the organization is a qualified charity, you may even be able to deduct your contribution.
What About Gifts to Children?
One of the most important things to know about the gift tax law is that it is applicable to gifts for children — Even your own children.
Opening a custodial brokerage account for a child in your life can be an effective way of avoiding filing a gift tax return later.
For example, let’s say you have a high-net-worth and know you’ll be making large financial gifts to a child in the future. Maybe you plan to buy them a house or give them a sum of money to travel after they graduate.
Both of those examples would be taxable gifts. If they exceed $15,000, you would have to file a gift tax return.
By opening a custodial account such, as a UGMA account, through EarlyBird, you can spread your gift out.
You can contribute up to $15,000 per year to the account without filing a gift tax return. Then, when the child reaches adulthood, that money is fully theirs, and they can use it for anything they want.
It’s not just parents who can contribute to a child’s EarlyBird account. Grandparents, aunts, uncles, and any other loved one can put money in. And again, gifting consistently throughout the child’s early years helps avoid having to file a gift tax return by gifting one large lump sum in the future.
Unfortunately, gifts to family and friends aren’t tax-deductible. On the contrary, some people may actually end up paying taxes on their generous gifts.
The good news is that the gift tax applies to very few people. Unless you find yourself gifting millions of dollars over your lifetime, you probably won’t have to worry about it.
This is good news for an adult looking to make an investment in the future of a child they love. You can transfer money into your loved one’s custodial investment account without worrying about gift taxes.