There may be a time when you want to give someone a gift in life. However, you must first understand the gift tax before you do so. While there are some exceptions, any gift is a taxable gift by the IRS’s definition. In other words, anything could be a taxable gift, including cash, jewelry pieces, cars, and real estate properties.
If you are thinking about gifting a piece of real estate to your children, you are likely if there’s a way to avoid paying the gift tax. Can it even be done, and if so, how do you do it? In this guide, we will explain what the gift tax entails and things you can do to avoid or reduce the real estate gift tax.
What is a Gift Tax?
According to the Internal Revenue Service (IRS), the gift tax is a tax on the transfer of property from one individual to another while receiving nothing or less than full value in return. Even though it’s called a “gift tax,” the tax applies whether or not the person giving the property intends the transfer to be a gift.
Gift tax is a federal tax, and there are no state gift taxes to worry about as of 2022. For some people, this can be a house gift tax. But as mentioned earlier, just about any gift you give to someone can be taxed. The donor of the gift is typically the one held responsible for reporting and paying the gift tax. On or before the Tax Day (April 15) of the calendar year following the year in which a gift is made, the donor must file a gift tax return using Form 709.
Even though you’re likely to be subject to the gift tax when you transfer property, there is an annual gift tax exclusion of $16,000 per person for 2022. So if you give less than $16,000 in a year, you don’t need to worry about this. But any more than that, you will be responsible for filing a federal gift tax return.
While just about every gift is considered a taxable gift, there are some exclusions. Gifts under the $16,000 limit will not be taxed. Meanwhile, any gifts you give to a spouse or a political organization are exempt from the gift tax. Also, if you pay tuition or medical expenses for someone, no gift tax would be applied to them either. However, if you simply give them the money for their education or medical expenses, that won’t be an exclusion. So you need to be careful in terms of what you gift and how much.
How Does the Gift Tax Work?
Since the annual exclusion is $16,000 in 2022, if you give eligible gifts over $16,000 this year, you will have to file a federal gift tax return.
However, it is essential to know that the annual exclusion can be doubled if you are married since you can combine your individual allowances. This means an annual exclusion of $32,000 in 2022.
Annual Exclusion Limit
But even if you happen to go over the annual exclusion, there is no need to worry just yet. You may be able to use the lifetime exemption.
The lifetime exemption is an additional amount that can be given throughout your life. The IRS allows a lifetime tax exemption on gifts and estates up to a certain limit. As of 2022, the limit is $12.06 million, up from $11.7 million in 2021. Like the annual exemption, this lifetime exemption is also doubled if you are married. In other words, you and your spouse combined can enough a lifetime exemption of $24.16 million in 2022.
Lifetime Gift Tax Exemption Limit
Annual Gift Tax Exclusion vs. Lifetime Exemption
However, the lifetime exemption works differently from the annual gift tax exclusion. With the annual exclusion, if you give $16,000 one year, the following year, you will automatically get the same amount (or whatever the government decides the amount for that year will be) back to give again.
But with the lifetime exemption, once you use up some of it, it never comes back. Any amount you give over the $16,000 annual limit will go toward your lifetime exemption. Think of it like a giant barrel that catches all of the gifts you make above the $16,000 yearly limit and stops you from paying taxes on them. Of course, the “barrel” will eventually fill up. When you run out of lifetime exemption, you will be responsible for paying taxes on anything exceeding the annual exclusion limit.
Every time you use up a portion of your $12.06 million, it whittles down your ability to give in the future, so be careful. The gifting a house tax implication is certainly something you should think about before making any decision about what to do with your home, especially if you have begun to tap into this lifetime exemption.
The gift tax rates range from 18% to 40%. The amount you are taxed depends on how far beyond the annual exclusion limit you go. The more you give above the limit, the higher the taxes.
For example, let’s say that a loving grandparent wants to gift their grandchild real estate worth $116,000. Suppose, in this case, the grandparent has already used up their lifetime exemption. The first $16,000 will not be taxed based on the annual exemption. The next $10,000 will be taxed at 18%, the following $10,000 at 20%, and then the tax rates climb by 2% with every additional $20,000 exceeding the exclusion amount, with the highest rate the parent pays being 28% for the amount between $80,000 and $100,000. See the table 2022 Federal Gift Tax Rates below for a detailed breakdown.
Here’s how the math works in this example:
2022 Federal Gift Tax Rates
|Gift Amount (after annual exclusion)||Tax Rate|
|$0 – $10,000||18%|
|$10,001 – $20,000||20%|
|$20,001 – $40,000||22%|
|$40,001 – $60,000||24%|
|$60,001 – $80,000||26%|
|$80,001 – $100,000||28%|
|$100,001 – $150,000||30%|
|$150,001 – $250,000||32%|
|$250,001 – $500,000||34%|
|$500,001 – $750,000||36%|
|$750,001 – $1,000,000||38%|
|$1,000,001 and more||40%|
Learn more: Capital Gains on Selling Gifted Property
Gift Tax vs. Estate Tax
Gift tax and estate tax are often confused for one another, but they are, in fact, very different. The gift tax is for the transfer of property throughout a person’s lifetime, whereas the estate tax is applied when the property is transferred after death.
While some people do indeed wait to transfer property until after they have passed, it is becoming more and more popular for people to give things like property and other things to their children, friends, or loved ones while still alive.
Ways to Avoid a Real Estate Gift Tax
Now that you know what the gift tax is and how it works, we can finally begin to look at a few ways to avoid it. In the case of real estate gift taxes, the avoidance will generally be thanks to the lifetime exemption that we mentioned earlier.
Chances are your real estate gift is likely to be over $16,000. As long as it is not over your lifetime exemption room (as much as $12.06 million), you won’t need to pay the tax. You will still need to file a federal gift tax return every time you go over the annual limit, but you will not be responsible for paying for it. This return will also help you keep track of how much lifetime exemption room you have.
If you have other plans for gifting later in life, you need to be careful to know how much of your lifetime exemption you have left. Because if not, you could be in for a hefty tax bill that you simply didn’t see coming. People who plan to give less than $12 million in their lifetime won’t need to worry about paying a single cent in real estate gift tax unless the rules change drastically.
While you can avoid paying most real estate gift tax with the lifetime exemption and annual exclusion, some people might want to preserve these exemptions for the future and may be uncomfortable with using a large chunk of it on one single gift.
Here are some alternatives to gifting real estate that might be suitable for you if you want to hold onto your lifetime exemption.
Create a Life Estate
The first option is to consider creating a life estate. It is a way to pre-gift your home while remaining a joint owner. Since the donor is essentially still an owner of the property, no gift tax will be applied. This will allow you to retain full ownership and use of the property for the remainder of your life if you choose. The property will simply transfer to the other owner or beneficiary when you die. As long as there are no plans to sell the home, this can be an adequate solution for many.
Use a Living Trust
You can also place the home in a living trust for your children. A living trust is simply a legal document that makes it easier and more affordable to transfer property or other assets after your death. A living trust eliminates the need to go through the court, making the entire process much smoother and quicker. Going with this option can also help to avoid potential disputes that can occur, as well.
Sell the Property at Fair Value
Of course, another option is to simply sell the property for a fair price to the person you would gift it to. Then, your child can rent the home to you (or to someone else), and you can continue to live there for the rest of your life. Once you pass, the home is theirs, and they can do with it what they want.
These options may not be perfect and may not instantly make your child or the beneficiary the instant owner of the property for nothing. But if your primary goal is avoiding real estate gift tax and maintaining a sizable portion of your lifetime exemption, they are helpful strategies to utilize.