It may seem curious that the IRS imposes a tax on people who give away money or property. Even if you file income taxes every year, you may not know that there is a federal gift tax unless you have given or received a valuable gift of money or property. The person getting the gift usually doesn't owe the gift tax; it's the donor who has to file a federal gift tax form with the IRS. So if your parents give you a piece of real estate, it's a gift of equity subject to the gift tax. And it's also a taxable gift if they sell it to you for less than its fair market value. But more than likely, the donor won't have to actually pay anything to the IRS for the gift. Under the federal tax code, there is an annual gift tax exclusion and a lifetime exclusion that shelter all but the most valuable gifts from taxation.
What Does "a Gift of Equity" Mean?
You know what a gift is. It is something someone gives you and doesn't expect payment for. A gift can be anything from a pair of socks to a seat on the New York Stock Exchange. It can also be a gift of equity in real estate, like a house or an apartment building or an office complex.
Gifts of real estate are more often than not made between family members. Many parents gift real estate in order to get their kids set up in an affordable house of their own. For example, when parents retire and move to a new, smaller dwelling, they may give the child the old house, or, more likely, sell it to her for the amount of the outstanding mortgage. This is considered a gift of equity in real estate, and that equity is subject to the federal gift tax.
The gift tax doesn't just apply to gifts of cash or equity, the IRS can also claim gift tax if someone forgives a debt you owe, makes a loan to you at a below-market rate or transfers insurance policy benefits to you. It can even apply to certain property settlements in divorce cases.
Valuation of a Gift of Real Estate Equity
If someone gives you $20,000 in new $100 bills, both you and the IRS have no trouble putting a value on the gift. But it's a little more complicated with a gift of real estate equity. Let's say your parents give you their cabin in Santa Cruz, California. They bought it 40 years ago for $20,000, and they paid it off long ago. Since market values in the area have skyrocketed, and if they sold it on the open market, they could probably get $400,000 for it. So, what amount must be reported to the IRS as a gift on this transaction?
It's not hard to guess right on this one. Under IRS tax rules, every gift of real estate is considered a gift of equity. The value of real estate for gift tax purposes is set at fair market value. This means that your parents have to pay gift tax on the price that the real estate would bring on the open market. According to the terms of the IRS rule, the value of the gift at fair market value would assume a sale between a willing buyer and a willing seller in a situation when neither is distressed or feels compelled to buy or sell quickly. It also factors in everything relevant about the property location and condition. Which means, in the above example, the gift tax value of the house would be $400,000.
How Much Money Can Be Gifted Without Being Taxed?
The IRS doesn't impose a gift tax on every single penny someone gives away. First, there is no gift tax imposed on gifts between spouses, nor to qualified charitable organizations or for direct payment of college tuition. In addition, there is an exclusion amount, which is a set amount, subject to occasional increase, that one person can give to another person without having to pay a gift tax. For 2018, it is $15,000.
The gift tax exclusion is calculated on an annual basis. That means that if someone gives you $15,000 for Christmas, she would not have to report that to the IRS, assuming it was her first gift to you of the year. But that same person could turn around and gift you another $15,000 on January 1 of the following year and that would also be excluded from gift tax reporting. If you have wealthy (and generous) parents, each parent could gift you $15,000 on Christmas and another $15,000 on New Year's Day for a total gift of $60,000 that would not incur gift taxes. If you are married, your parents can double the exclusion amount by making the gift to you and your spouse. They could each gift you and your spouse $30,000 each year, or $60,000 in one year and $60,000 the next January. That means that $120,000 could change hands in a very short time without incurring gift tax.
Note that a gift that is under the exclusion amount has no effect at all on the federal tax return of the person giving the gift. There is no deduction for a gift unless the gift was to charity. Generally, the person giving the gift must pay any gift tax due on it, or shelter the gift by using his lifetime exclusion. But if that person doesn't pay, the person getting the gift will have to pay it.
Lifetime Gift Tax Exclusion
If people giving real estate equity do go over the annual limit, there is a lifetime limit to fall back on. The lifetime estate and gift tax exemption for 2018 is $5.6 million, and effectively shelters that much from tax. The lifetime gift tax exemption is also the estate tax exemption that shelters estate money from taxation when you die. That means that any use of it while the donor is alive reduces the estate tax exemption available at death.
This is the way it works. If a wealthy individual gives his 10 children real estate valued at $1,150,000 in one year, the annual gift tax exemption would be $150,000, i.e., $15,000 per child. He would still have to pay gift tax on $1 million. He can apply this to his lifetime exemption to shelter the entire amount of the gift, but then his estate tax exemption diminishes to $4.6 million.
Gift of Equity Tax
In order to keep track of these types of transactions, the IRS requires that those people giving gifts of cash, property or equity file IRS Form 709, the United States Gift (and Generation-Skipping Transfer) Tax Return. It must be filed by April 15 in the year after the gift was made. If you get an extension to file your federal tax return, it automatically extends your IRS gift tax return form due date. Although technically you have to pony up any gift taxes due by April 15, in practice this is usually not a problem given the lifetime exclusion limit of over $5 million.
Be careful to document the IRS gift of equity transaction well. You'll need to get a professional appraisal on the property, then attach a copy to the gift tax return. Also attach any other documents related to the transfer of equity. Note that spouses cannot file a joint gift tax form, even if they file a joint income tax return. Each must file their own form 709.
And, if a gift is of real estate that is owned as community property, it is deemed to be made in equal shares by the spouses. For example, if a child receives a house valued at $200,000 as a gift from her parents who owned it as community property, the IRS considers it a gift of $100,000 by each spouse. Each of the parents must file a gift tax return.