Gifts Are Not Income
The Internal Revenue Service (IRS) doesn’t consider gifts to be income, even if the gift is cash. Your wealthy grandmother can give you a million dollars, and you won’t owe the IRS a single dime. You won’t owe the IRS a gift tax, either, if your grandmother gives you a non-cash gift. You will only owe this tax if you decide to give the gift away or if you sell it for significantly less than its fair market value.
The Annual Exclusion and the Lifetime Exemption
In tax year 2022, you could give away $16,000 per year in cash or property to any individual without incurring gift tax. The limit has gone up to $17,000 for 2023. If you give away more than that, it will be applied to your lifetime exemption. The lifetime exemption is $12.06 million for 2022 and $12.92 million for 2023. The exemption gradually reduces by each gift you give over $16,000 per person per year in 2022 ($17,000 for 2023). Anything left over would protect your estate from paying the estate tax when you die, assuming your estate’s value is equal to or less than the remaining lifetime exemption.
Selling a Gift Below Market Value
If you sell a gift you’ve been given, the way it’s treated depends on the market value of the gift and how much profit you make, if any. Say your grandmother is a famous artist and she gifts you a painting worth $1 million. You turn around and sell it for $500,000. The IRS considers that you would have given a gift worth $500,000 to the buyer since your grandmother’s artwork was valued at $1 million. That’s $485,000 more than your annual $15,000 exclusion, so you’d have to subtract the $485,000 from your lifetime exemption.
The Capital Gains Cost Basis of Gifted Property
If you decide to sell the gift at fair market value, you must report the capital gain or loss, and you could owe capital gains tax if you make a profit. Capital gains or losses on gifted property received during the donor’s lifetime are calculated according to the original owner’s cost basis in the asset. But its cost basis would be “stepped up” to what it was worth on the date of their death if you were to inherit the property instead—that is, if the original owner decided to wait until their death to pass it to you. This can make a big difference. The gift basis is what the original owner paid for the property, plus or minus any adjustments. Typical adjustments that increase basis are substantial repairs and improvements, along with any expenses incurred in the sale, such as broker’s commissions. Typical adjustments that reduce basis include depreciation that the previous owner might have claimed for renting out the property. This depreciation is passed to the new owner as well. The recipient’s gain or loss on the gift would be the sale price minus this adjusted cost basis.
An Example of Cost Basis Before Death
Let’s say that one of your parents transfers their $300,000 house to you before their death. They paid $80,000 for it 30 years ago and made $40,000 worth of improvements to it over the years. Your cost basis is therefore $120,000 ($80,000 plus $40,000). You’d realized a $180,000 capital gain if you were to sell the home for $300,000.
An Example of Cost Basis After Death
Now let’s say your parent transfers their home to you as part of their estate plan after death. The situation is much different because of that step-up in basis. There’s no capital gain to be taxed if the property’s fair market value is $300,000 as of the date of death and you sell it for $300,000. You get $300,000 in either case, but in the second scenario, you won’t have to give any of it to the IRS.
The Holding Period for Gifted Property
The recipient of the gift also receives the donor’s holding period in the property for determining whether a gain is long-term or short-term. It’s a short-term gain if the donor held the asset for one year or less. It’s a long-term gain if they held the asset for longer than a year. This holding period is an important distinction, because it determines the rate at which your capital gain is taxed. A short-term gain is taxed as ordinary income, according to your tax bracket. For tax years 2022 and 2023, ordinary federal tax rates range from 0% to 37%. The rates for long-term gains are 0%, 15%, and 20% for 2022 and 2023, depending on your taxable income. Most people fall into the 15% category. Long-term gains are more advantageous than short-term gains, tax-wise. Suppose you’re single and earn $80,000 in tax year 2023. You’d pay a 15% long-term capital gains tax, but you’d pay 22% for every dollar in the 22% tax bracket if the gain were short-term, and you were taxed according to your tax bracket. That’s a significant 7% difference.
Recordkeeping Tips for Gifted Property
Ask the donor to provide you with the cost basis of the property and to let you know the date it was originally purchased. Try to obtain a copy of an escrow statement or other documentation so you can prove the amount and the date of the purchase. You’ll also want to get an estimate of the fair market value of the property on the date of the gift transfer, because market value can sometimes come into play with gain or loss calculations. This estimate can be as simple as arranging for a property appraisal.
Tax Strategies for Gifted Property
Consider living in the home for at least two of five years before selling it if you receive real estate as a gift. This period of residency can help make you eligible for a capital gains exclusion of up to $250,000 on the sale of a primary residence if you’re single, or $500,000 if you’re married and file a joint return. Other rules apply as well.
