Finance

Liz Weston: Large gifts potentially reduce the amount a wealthy donor can pass on to heirs tax-free

Dear Liz: You recently wrote about the capital gains tax implications when someone sells a house they got, versus one they inherited. Would you elaborate on the consequences of the estate for the donor if the person has a large estate? Would their estate pay the gift tax?

The answer: Few people have to worry about gift or estate taxes, for reasons that will become obvious in a moment. But large gifts can potentially reduce the amount a wealthy donor can pass on to heirs tax-free upon death.

This is because the gift and estate tax systems are combined. Gifts above the annual exclusion amount — which is $17,000 per recipient in 2023 — reduce the donor’s lifetime gift and estate tax exemption, which is $12,920,000 in 2023.

Let’s say a donor gives a million dollar house to a friend. The amount that exceeds the annual limit of $17,000, or $983,000, is deducted from the donor’s lifetime limit. If the donor died in 2023, the amount of their estate in excess of $11,937.00 would be subject to estate tax. (Donors owe gift tax only after they give enough to exhaust that lifetime limit.)

Receiving property as a gift also means that the recipient may face more tax than if they had inherited the property.

The previous column mentioned that when someone inherits a house, the tax basis of the house is “stepped up” to the current market value. This means that the value that occurred during the lifetime of the previous owner is not subject to tax.

If someone is gifted a house by a living donor, different rules apply. No increase in value. The recipient receives the donor’s tax basis, which is usually what the donor paid for the home, plus any qualifying improvements.

When the house is sold, that basis is deducted from the income to determine the potentially taxable gain. The recipient could face capital gains tax on the appreciation that has occurred since the original owner purchased the home.

On the other hand, gifting assets during life is one way to control the size of a potentially taxable estate, says Los Angeles estate planning attorney Burton Mitchell. Once a house is gifted, for example, its future value will not increase the donor’s estate.

Anyone with an estate large enough to worry about these taxes should, of course, consult with an estate planning attorney about the best strategies for their situation.

Liz Weston, a certified financial planner, is a personal finance columnist NerdWallet. Questions can be directed to her at 3940 Laurel Canyon, ext. 238, Studio City, CA 91604, or by using the “Contact” form at asklizweston.com.

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