This is an excellent way to reduce estate taxes because you are reducing the size of your taxable estate. (Just make sure you don't give away any assets you may need later.) But even more satisfying to many people is that you can see the results of something that may not have happened without your help.
You can currently give up to $11,000 per recipient each year. (If you are married, you and your spouse can each give $11,000, for a total of $22,000 per recipient per year.) You can also give an unlimited amount for tuition and medical expenses if you make the gifts directly to the educational organization or health care provider.
Gifts do not have to be in cash. For example, if you want to give your son some land worth $44,000, you can give him a $11,000 "interest" in the property each year for four years.
As long as the gift is within these limits, you don't have to report it to Uncle Sam. Just the same, it's a good idea to get appraisals (especially for real estate) and document these gifts in case the IRS later tries to challenge the values.
What if you want to give someone more than $11,000 in one year? You can, it just starts using up your federal estate tax exemption. That's because the federal estate tax exemption is a combined gift and estate tax exemption. Under current law, it's the same tax. If you transfer the asset while you are living, it's called a gift tax. If the transfer is made after you die, it's called an estate tax. So you can either use part or all of the exemption now while you are living, or you can use it later after you die.
If your gift exceeds the $11,000 limit, you need to let Uncle Sam know - by filing an informational gift tax return (IRS Form 709) for the year the gift is made. The gift is applied to your federal gift and estate tax exemption. So you only pay a gift tax after you have used up your exemption.
Note: The amount of tax-free gifts (currently $11,000) is tied to inflation and may increase from year to year.
Pay The Tax Now - And Save
The tax rate is the same, whether you pay it now or after you die. But, it costs you less to pay the gift tax now than to pay the estate tax after you die.
As we explain in Part Three of "Understanding Living Trusts,®" after you die, taxable gifts you have made since 1976 are added back into your estate before estate taxes are calculated. (This is so Uncle Sam can calculate your estate taxes at the highest tax rate.) The amount you have paid in gift taxes is then subtracted from the estate taxes due. (Think of the gift tax as a prepayment of the estate taxes you will owe.)
But the amount you've already paid in gift taxes is not in your taxable estate when you die. You've already paid it to Uncle Sam. Making the gift now lets you forever remove the amount paid in gift tax from your taxable estate.
If, on the other hand, you keep the asset in your estate until you die, the amount you would have paid in gift taxes is still in your estate. This makes your taxable estate larger and increases the amount of estate taxes your estate will have to pay. Keeping the asset in your estate until after you die forces you to pay estate taxes on the amount you would have paid in gift tax. In effect, you're paying a tax on the tax!
This is best explained with an example. Let's assume you have used up your federal gift and estate tax exemption through prior gifts and, as a result, you are now in a 49% gift and estate tax bracket. (The top estate tax rate in 2003 is 49%.)
If you give your children $1 million as a gift (while you are living), the gift tax will be $490,000 ($1 million times .49 = $490,000). You, the donor, pay the gift tax. So your children would receive the full $1 million, and an additional $490,000 would be removed from your taxable estate to pay the gift tax. So, it would cost you $490,000 to give your children $1 million.
If, on the other hand, you wait until after you die, it would cost you $1,960,784 to leave them $1 million (49% of $1,960,784 = $960,784 in taxes, leaving a net of $1 million for your kids). That's $470,784 more than if you gave them the $1 million while you were living!
Of course, there is an exception you need to be aware of. Any gifts you make within three years of your death will be included in your estate - and so will any gift tax you pay on them. This is to prevent you from making enormous gifts "from your deathbed" so you can get the gift tax out of your estate. (Yes, Uncle Sam already figured that one out!)
Assets Are The Best To Gift?
But you also have to look at the estate tax savings compared to what the recipient may have to pay in capital gains tax if the asset is later sold. Remember, when you give away an appreciated asset, it keeps your original cost basis (plus any gift tax paid). And if the recipient decides to sell it, he/she will have to pay capital gains tax on the difference between the selling price and what you paid for it.
If, on the other hand, you don't give it away and it stays in your estate, the asset will receive a full step up in basis as of the date of your death (saving capital gains tax). But, depending on the size of your estate when you die, there may be estate taxes. So it's a trade off.
Currently, the maximum federal long term capital gains rate (for assets held longer than 12 months) is 20%, while estate taxes start at 41%. But it isn't always better to give away an asset and let the recipient pay the lower capital gains tax. Among other things, you have to consider what you paid for the asset, what it's worth now, what you think it will be worth when you die and if the recipient plans to sell or keep it.
Gifts From Your Living Trust
That's because, in the past, if the grantor died within three years of making a gift directly from his/her living trust, the IRS tried to include the gift - -even annual tax-free gifts -- in the grantor's taxable estate.
You don't have to play this "shell game"
anymore. The Taxpayer Relief Act of 1997 stated that
gifts made directly from a revocable living trust are
considered the same as if they were made directly from
you, even if they are made within three years of your
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