Explainer: the Estate and Gift Tax
The Estate and Gift Tax is a tax scheme that imposes a tax on the transfer of an asset. The Estate Tax (otherwise known as the Death Tax; they’re the same thing) requires the transfer to be made after the giver’s death. So, think of an inheritance when you think of the Estate Tax. And the Gift Tax requires the transfer to be completed during the giver’s life. So, think of a birthday or anniversary gift. But in both scenarios, something is being transferred. Also keep in mind that the transfer is being made gratuitously, meaning there is no sale taking place. It must be a gift.
The Estate and Gift Tax is a tax on the grantor of the transfer. That’s the person or estate of a person that is making the gift (the giver). The tax is imposed by the Internal Revenue Service (IRS), our federal taxing authority. Note that we do not have a federal inheritance tax–a tax on the recipient of a transfer. There are a few states that do have an inheritance tax, but California is not one of them. An inheritance tax may apply if the recipient of a gift resides in a state or country that imposes an inheritance tax.
The Estate and Gift Tax is really easy to calculate. It’s a flat tax, meaning that it applies equally to every grantor of a transfer. The federal government imposes a flat 40% tax of the fair market value of the asset being transferred. That is not a typo. As an example, if I gave my friend $1,000 for her birthday, I would have to pay $400 to the IRS for making this gift. It’s an identical result if I left my friend a $1,000 inheritance from my estate. My estate would be on the hook for a $400 tax.
Hold up. Why have we not heard of anyone paying this tax?? And why is no one upset with this??
Enter: the estate and gift tax exemption.
The Estate and Gift tax are linked by an exemption amount. An exemption is a magic number that Congress selects, and it applies to every US citizen and green card holder. Congress has decided that so long as you do not make gifts in excess of your exemption amount, then no tax is owed. The exemption amount is set periodically by Congress, and it gets adjusted for inflation annually. When someone dies, all of the gifts they made during their life are added to the value of stuff they own upon their death, and that total is measured against the exemption amount.
Ok, simple enough. How do we know our applicable exemption amount?
The current exemption amount is set at $10,000,000 per person. That’s not a typo, either. It’s indexed for inflation annually. So for 2023, the exemption amount is $12,920,000. Additionally, if you’re married, you essentially get to combine your exemption amount with your spouse’s exemption amount. In short, if you are an unmarried person, you can transfer up to $12,920,000 in assets and pay no estate taxes. If you’re married, you can jointly transfer up to $25,840,000 in assets and pay no estate taxes. Only the amount that exceeds the exemption is subject to the 40% tax. For example, if an unmarried person dies owning $14,000,000 in assets, only $1,080,000 ($14,000,000 - $12,920,000) is subject to the 40% flat tax, or $432,000 in taxes owed on a $14,000,000 estate.
How does the IRS know whether lifetime gifts were made, and how much they amounted to?
Just like we are required to report our income every year on a Form 1040, we are also required to report any gifts made in a given year on a Form 709. When you report the gift, the IRS walks over to your file and deducts the amount of that gift from your $12,920,000 exemption amount. No taxes are owed until you run out of exemption! But here’s the thing: you only have to report gifts that are in excess of what is called the annual exclusion.
The annual exclusion is another number set by Congress that allows each person to make a certain value of gifts every year, to every recipient, and not tell a soul, including the IRS. The current annual exclusion is set to $17,000. So, for example, I can give each one of my friends up to $17,000, per year, and not have to report that on a Form 709. I can combine my exclusion with my spouse’s exclusion, and make up to $34,000 in gifts per recipient, per year, and not report it on a Form 709. This is why you never hear of anyone filing gift tax returns after birthday parties. If only we were all so generous!
So what happens if, for example, parents assist a child with a downpayment of a home, in excess of $34,000 in a given year?
If a gift is made in excess of the annual exclusion, then you deduct the amount excluded and then file a gift tax return for the amount in excess. Let’s say parents give a $200,000 gift to a child to purchase a home. They would deduct the $34,000 ($17,000 x 2 parents = $34,000) they can jointly give to the child in a year and not report it, then report the remaining $166,000 ($200,000 - $34,000). Each parent would file a Form 709 declaring a gift of $83,000 each. The IRS walks over to each parent’s file, and deducts $83,000 from each of their $12,920,000 exemption. If they haven’t gone over the exemption amount, no taxes owed on that transfer.
Whew! That’s a lot of information to digest.
To sum it up, we all get an Estate and Gift Tax Exemption. It’s set by Congress, and annually it gets adjusted for inflation. This year’s amount is set at $12,920,000. Spouses can effectively combine that amount. The tax is a flat 40% tax of the fair market value of the transferred asset, and only the giver of the gift/inheritance is on the hook. But the giver only pays it when they exhaust the exemption amount, and only the amount in excess of the exemption is taxed. Additionally, only lifetime gifts in excess of the annual exclusion (currently $17,000 per year, per recipient) count against the exemption amount. If you never exceed the exemption amount, you don’t pay any tax.
That all being said, the exemption amount is set to reduce in roughly half (to ~$6,000,000 per person) on January 1, 2026, unless Congress acts. Keep your eyes peeled for the coming months and elections to see where the exemption amount lands.