What is the gift tax and how does it affect you?

Today, giving away certain items to your loved ones is common in most families and makes sense. Some gifts bring them immediate joy. And other gifts can improve their lifestyle right now while you are here to enjoy it with them. Some gifts are needed now, not later, like baby gifts.

You get to feel the excitement of gift giving and see the appreciation.

But what is a gift for tax purposes?

For tax purposes, the federal government considers a gift any transfer of money or property to other people if you get nothing, or less than full value, in return.

This inclusive definition includes almost any gift you give or can imagine.

And the gift tax obligation is on the gift giver, called the donor, and not on the recipient.

Yet, most people will not need to pay any gift tax, and here is why.

The federal government has gift tax exemptions. If you stay under the exemption thresholds, you will owe no gift tax at all.

But if you do not stay under the thresholds, the gift tax rates range from 18% to 40%, and the gift giver usually pays the tax. The details and rate are outlined in instructions to IRS Form 709.

The two exemptions are an annual exemption and a lifetime exemption.

The annual exemption is easy to understand and use. The lifetime exemption is slightly more complicated. It is linked with the exemption allowed for federal estate taxes into a unified credit.

The IRS allows a lifetime gift exclusion. You are entitled to give away up to the lifetime gift exclusion amount without paying any gift tax.

And this is separate from the amounts you give away tax-free annually because they are under the annual gift tax exclusion amount. Your annual gift giving does not eat into your lifetime exclusion until you exceed that annual exclusionary amount.

For example, if you gave someone a $20,000 gift this year, $16,000 of it would have no tax obligation because of the annual exclusion. The remaining $4,000 would be deducted from your lifetime exclusionary amount.

But you don't pay taxes on that amount this year. You don't pay any gift taxes until you exceed the lifetime exclusionary amount.

The IRS gives an exclusionary amount for the combined dollar amount of gifts given away and the value of your estate.

The total amount is a whopping $12.06 million for 2022. This is the amount you can give away over your lifetime tax-free. For couples, the amount is $24.12 million.

But you must not forget that the lifetime gift tax exclusion is shared with the estate tax exclusion.

The more money you give away above the annual gift exclusion, the less money you can leave to your heirs tax-free when you die.

For example, assume that you gave away up to the annual gift exclusion this year. Then you gave away $12.06 million. You have no gift tax obligation because you did not exceed the lifetime threshold. But now your estate has no amount of the unified credit available and will start paying taxes from dollar one.

Or assume that you never gave away any amount above the annual gift exclusion during your lifetime. Your estate will have the total lifetime exemption amount available, $12.06 million as of 2022. If you died today and never used any of the unified credit for gift taxes, the first $12.06 million of your estate would be tax-free.

How much of the unified credit you choose to use for gift tax or estate tax exclusions is up to you. But the lifetime amount is for both of them combined.

But beware of the current legislation as you plan your future gift and estate strategies.

Because of ffederal law, the current $12.06 million exemption is temporary and only applies up to the 2025 tax year.

Initially, the estate tax exemption was set at $5 million in 2011, adjusted for inflation.

In 2017 the Tax Cuts and Jobs Act doubled that exemption for 2018-25, with inflation adjustments. The exemption was $11.7 million in 2021 and increased to $12.06 million for 2022.

The law will reduce the exclusion for estates by restoring the exemption to pre-TCJA levels by the 2025 tax year.

Unless Congress acts, and this is always a big if, the estate exemption and, therefore, the unified credit will be cut in half and back to its $5 million value, adjusted for inflation.

Most Americans will not be affected by the reductions. Even with the reduced gift and estate exemptions, they will still be able to gift and bequeath their assets relatively tax-free to their family and heirs.

But there are opportunities and strategies to discuss with your financial advisor for those with assets and income high enough.

Suppose you believe the higher exemptions will sunset. Is there anything you can do right now to lock in the $12.06 million exemption while it still exists? And if you did use those higher exemptions, how will the IRS tax you after the exemptions are reduced.

A straightforward strategy is to gift higher amounts before the exemption is reduced if you can afford to do so. You get to see your loved ones enjoy and take possession of the large gifts, and you pay no gift taxes currently.

Because of the exemptions and unified credit, most Americans will not owe any gift or estate taxes. But to ensure you pay no gift taxes, or the minimum possible, you should discuss the best strategies with your financial planners. Some of the more popular ones are:

• If you are a couple, always consider gift splitting. In 2022, this allows you to give $32,000 per recipient and still stay below the threshold. Remember, when gift splitting, you must file IRS Form 709 even when no gift tax is due.
• Find a proper way to pay bills directly instead of gifting the money. This is especially common with medical and educational bills.
• Spread out the gifts. Instead of giving an entire piece of real estate, you can place the real estate in an LLC and give away a percentage of the membership each year. Be sure not to go over the yearly exclusionary amount.
• Factor in the size of your estate and your estate plan and determine how much you can gift and still have a tax-free estate.
• Talk with your financial professional to learn how you can distribute your assets in ways that won't trigger the gift tax. Large and complex businesses and assets can often be gifted in parts that will not generate gift tax obligations.