Generosity is often considered a positive quality, but being too generous with money can increase taxes. The Internal Revenue Service imposes a gift tax that applies to gifts of money and fair market value of gifts of property. If you plan to give or receive a large sum of money, it is important to understand gift tax rules and to know exactly how much money a donor can give on a tax-free basis.
Gift Tax Basics
While the government imposes a gift tax, it doesn't mean you have to pay taxes on every DVD, action figure and dollar bill that you give during your life. Small gifts of money and property have no negative tax consequences. The only time the gift tax comes into play is when you give more than $13,000 in cash and property to a single person over the course of a year. If you give gifts that exceed that amount, you may owe gift tax. If you are the recipient of a large gift, the giver is responsible for paying gift tax, although the Internal Revenue Service says that under special arrangements a gift recipient can elect to pay gift taxes on behalf of the giver.
Annual Exemption Rules
The $13,000 that you can give each year on a tax-free basis is the annual gift tax exemption. Married couples can each give up to the $13,000 to the same recipient, meaning a couple can give up to $26,000 a year to a single recipient tax-free. In addition, a different annual exemption applies to every gift recipient, so you could give up to $13,000 a year to as many people as you wish without any tax consequences.
When a gift exceeds $13,000, the excess is subtracted from a lifetime "unified credit" that equals $5,120,000 in 2012. As long as the giver hasn't used up his unified credit, he doesn't pay gift tax. In other words, a giver would have to give away over $5 million over the course of his life before paying any gift tax. Once a giver uses up his entire unified credit, further gifts that exceed the annual exclusion are subject to gift tax.
The lifetime unified credit carries over after death to reduce estate taxes. If you never give gifts in excess of $13,000 a year, your full unified credit gets applied to the value of your estate. This means that a decedent can leave behind up to $5,120,000 worth of assets that pass on to his heirs without incurring estate tax. Since large gifts reduce the unified credit, giving large gifts can result in owing more estate tax for wealthy individuals. In essence, the gift tax prevents wealthy people from giving away all of their money to avoid estate taxes.