We all want to do good in this world, especially regarding the people we love and the causes that are close to our hearts. That’s why gifting the wealth you’ve built can be such an incredible way to give back.
But before you start handing out all the assets you’ve got, it’s important to do your research.
Because the Internal Revenue Service (IRS) has rules about how much money you’re allowed to gift to an individual.
That means in certain cases, you may end up paying taxes on the financial gifts you’re passing on to loved ones.
Fortunately, there are several ways you can legally avoid paying the federal gift tax.
This guide explains what gift tax is, ways to avoid gift tax, and who’s responsible for paying gift tax when it can’t be avoided.
What is the Gift Tax?
If you’re considering investing in a child’s financial future, there are plenty of dynamic investment vehicles (like UGMA custodial accounts) that you can use to save for a minor in a tax-efficient way.
That being said, a lot of the contributions you make to a minor’s future will still be subject to an IRS tax — even though the contributions are a gift.
This tax is known as the “gift tax.” The gift tax is essentially a levy on the transfer of property from one individual to another when the gifter receives nothing (or less than the item’s full value) in return.
Congress introduced the gift tax in 1932 as a way to keep donors from dodging their fair share of the IRS estate tax by transferring all their wealth to others before they passed away.
Fast-forward 90 years, and the gift tax now applies to the transfer of most assets. More importantly, the gift tax applies whether or not you as the donor intend the transfer as a gift.
What does the IRS consider a gift?
When it comes to what counts as a gift, the IRS uses an incredibly broad definition.
For the purposes of the gift tax, a “gift” is considered any type of property or asset that you transfer to somebody else. This could include cash, property, or even the income you’ve received from selling a property.
It’s really important to bear in mind that the gift tax can apply even if you’re selling property.
According to the IRS, if you haven’t received a fair market value for an asset you’ve sold to another person, it qualifies as a gift.
That means if you buy a brand-new Audi for $50,000 and then turn around and sell it to your best friend for $1,000, you’re underselling the car by so much money that it counts as a gift.
The same rule applies to an interest-free loan or reduced-interest loan.
Letting someone borrow a big chunk of money without asking for interest may qualify as a gift under the gift tax rules. This one can be sort of a gray area, so it’s worth consulting a financial advisor or even getting in touch with the IRS when it comes to loans.
Either way, you get the idea: you’ve got to be careful when you gift assets to others because you could end up getting saddled with a tax burden as a result.
Fortunately, there are several ways you can easily avoid gift tax — you just need to be organized and know your rights.
How to Avoid the Gift Tax
At first glance, the gift tax can seem a little scary. After all, you’ve probably worked really hard to build generational wealth. Getting taxed just because you want to pass that on to the important people in your life sounds pretty unfair.
Well, believe it or not, the IRS agrees with you. That’s why there are several exclusions built into the gift tax so that there are ways to legally avoid paying it.
To give you an idea of how to avoid the gift tax, we’ll quickly break down a few of the most common ways to legally minimize your gift tax obligations.
The gift tax exclusion
Although the IRS applies the gift tax to a broad range of gifts, you’re allowed to gift a certain annual amount of cash or other assets to an individual without being penalized.
This threshold is called your “gift tax exclusion.” More often than not, you’ll hear people referring to it as the “gift tax limit.”
This limit is subject to change, but for the 2021 tax year, the annual gift tax exclusion comes in at $15,000 per person per year. If you gift below this amount to a single individual in a given year, it normally won’t be subject to gift tax.
The important thing you’ve got to bear in mind here is that your annual exclusion is per gift recipient — not the total sum of all the cash you’ve gifted.
For example, you can give an annual exclusion gift of up to $15,000 to your daughter, another $15,000 to your nephew, and another $15,000 to the kid next door all in the same year without being required to file a gift tax return to the IRS.
You’ve also got a “lifetime limit.”
At present, the IRS lifetime gift tax exclusion limit is $11.7 million. This means that if your lifetime gifts ever exceed $11.7 million, you’ll likely need to pay gift tax.
It’s also worth bearing in mind that your annual exclusion is per person. If you’re married and joint file with your spouse, you as a couple can then give away a combined $30,000 as your annual gift tax exclusion.
If you ever give more than your annual exclusion limit, you’ll be expected to file IRS Form 709 as part of your annual tax return to disclose the gift.
At the end of the day, the gift tax exclusion is the simplest and most common way to avoid paying the gift tax. You’ve just got to stay organized to make sure you’re always within the limit.
One way to help fund the financial future of a child you love is to set up a UGMA custodial account for that child.
You can then use the gift tax annual exclusion to gift up to $15,000 per year toward that child’s account, tax-free. This will help them build up a nest egg that will be ready when they hit the age of majority.
Paying tuition or medical expenses
While your annual gift tax exclusion is limited, you can benefit from unlimited gift tax exclusions if you’re paying for certain medical expenses or qualified tuition fees for school.
In terms of what qualifies as a medical expense under the medical expense gift tax exclusion, the IRS specifically mentions certain medical care, including costs associated with diagnosis, cure, mitigation treatment, or the treatment or prevention of disease.
You’ll also be granted a medical gift tax exclusion if you gift money to pay for any procedure affecting the function or structure of the body, transportation and lodging during medical care, long-term care services, or even health insurance premiums.
In terms of what qualifies as an education expense, the tuition expense gift tax exclusion is pretty limited. You can only avoid the gift tax if you’re paying for someone’s tuition fees.
Textbooks, supplies, food, or accommodation don’t qualify for the exclusion — so if you gift money to pay for these things, you’d be subject to the gift tax (assuming you contributed over your annual exclusion).
Gifting assets to a spouse
If you want to gift a high volume of assets to your spouse, you’re in luck. Gifts between spouses are covered by an unlimited marital deduction.
The marital deduction rule says you can give every asset you own to your surviving spouse (whether you’re alive or dead) without having to pay gift tax or estate tax on the value of those assets.
One point to bear in mind is that when the IRS talks about “spouses,” they mean you need to be legally married. Registered domestic partners or civil union partners don’t benefit from the unlimited marital deduction. But legally married same-sex couples do qualify just like any other couple.
There’s one more caveat here. The unlimited marital deduction only applies to your spouse if they’re a U.S. citizen.
If your spouse isn’t a citizen, there’s a limit to how much you can gift them without having to pay the gift tax. Luckily, the annual exclusion for gifts made to non-citizen spouses is way higher than the normal annual gift tax limit.
You can gift a non-citizen spouse up to $159,000 in the current 2021 tax year without incurring the gift tax.
Gifting to a political organization
If you want to make a large gift to a political organization, that gift will normally be exempt from gift tax. That being said, there are a couple of important definitions you’ve got to bear in mind.
By “political organization,” the IRS is specifically talking about a group that advocates for an individual’s selection, nomination, or appointment to public office.
Gifts to social welfare organizations aren’t going to qualify for the political organization exclusion.
For the purposes of the gift tax, the IRS defines a social welfare organization as a civic league working to promote social welfare. If you give a large financial gift to one of these groups, you’ll likely need to report it and pay gift tax.
Giving assets to charities
You can also avoid the gift tax if you’re giving to a charity. That means if you gift to a government entity or a registered non-profit for educational, religious, charitable, or scientific purposes, you’ll normally benefit from an unlimited charitable deduction.
The same rule applies to gifting to a fraternal or veterans’ organization.
That being said, you’ll still need to report a gift you’ve made to charity to the IRS using Form 709.
If you give a slightly more complicated gift to a charity, you may need to file a gift tax return.
For example, let’s say you’ve given 50% of your interest in a property to a charity — but you give the other 50% to your cousin. In this case, you’d need to complete Form 709 and disclose both monetary gifts.
Who Pays the Gift Tax?
If you’re unable to avoid the gift tax through the legal exclusions we’ve already covered, you as the donor will normally be responsible for paying it.
There’s one exception to the rule, though. The person receiving the gift can agree to pay the gift tax, but only by special arrangement. This sort of agreement is usually made to help the donor avoid running over their annual or lifetime exemption.
Because the donor is responsible for paying the gift tax, they’re the ones who need to complete and file Form 709 disclosing any non-exempt gifts.
Nobody wants to get saddled with a huge tax burden. People work hard for their money, so they deserve to pass on their good fortunes by gifting some of that wealth to the people or causes that matter most to them.
Then again, the gift tax is considered a pretty reasonable way to make sure that people don’t abuse the rules to avoid paying federal estate tax. It works — but the IRS also appreciates that you should be able to gift a certain amount of assets to the ones you love.
That’s why there are so many exemptions and legal ways to limit your gift tax liability.
One of the best ways to gift money to the children you love is to invest in their financial future by setting up a UGMA custodial account for them.
By starting a custodial account for the kids in your life, you'll benefit from the gift tax annual exclusion and can help them build a nest egg over several years. By the time those kids reach the age of majority, the investments you’ve made will have opened up the door to loads of opportunities — without drowning you in extra taxes.
Ready to start gifting to a child in your life? Download EarlyBird today.