The IRS requires taxpayers to report gifts given above a certain threshold on their tax returns. This allows the IRS to monitor large gifts that could potentially be used to avoid estate and gift taxes. However, for smaller gifts under the reporting threshold, the IRS relies heavily on voluntary compliance and has limited visibility into these transactions.
What is considered a gift by the IRS?
The IRS defines a gift as any transfer of money or property where the giver receives nothing of equal value in return. Under tax law, gifts are not taxable income to the recipient. However, gifts above a certain size may be subject to gift tax for the giver.
Common examples of gifts include:
- Cash gifts for birthdays, holidays, or other occasions
- Contributions to a person’s education or medical expenses
- Interest-free or reduced interest loans that don’t have to be repaid
- The use of your vacation home or car free of charge
- Forgiving a debt that someone owes you
It does not matter if the gift is given directly or indirectly. For example, if you pay your child’s college tuition bill instead of giving them the money, it is still considered a gift by the IRS.
When do you have to report gifts to the IRS?
For 2023, you must report gifts totaling more than $17,000 given to any individual during the year. This $17,000 threshold applies separately to each person you give gifts to.
For example, if you give your son $10,000 and your daughter $15,000 in 2023, neither gift has to be reported because neither exceeds the $17,000 threshold. However, if you gave your son $25,000, you would have to report the $8,000 excess over the $17,000 limit for gifts to him.
In addition, spouses can combine their gift exemptions using gift splitting. This means you and your spouse can give up to $34,000 to an individual gift tax-free in 2023.
When do you pay gift tax?
You don’t actually pay gift tax until the total value of taxable gifts given over your lifetime exceeds the lifetime gift and estate tax exemption amount. This limit is $12.92 million per individual for 2023.
That means you can give up to $12.92 million in gifts over your lifetime without owing any gift tax. Any amount over that is subject to gift tax rates up to 40%.
Even if you give gifts over the annual reporting threshold, you likely won’t owe gift tax unless your total lifetime gifts exceed the $12.92 million exemption. But you still have to file a gift tax return for any year when you give more than $17,000 to an individual.
How does the IRS monitor taxable gifts?
The IRS has several ways to monitor gifts that exceed the reporting thresholds:
- Gift tax returns – Taxpayers who give more than $17,000 to an individual in a year must file a gift tax return (Form 709). This allows the IRS to track lifetime taxable gifts.
- Audits – The IRS can audit taxpayers and review documentation to identify unreported large gifts.
- Third-party reporting – Financial institutions must report certain transactions over $10,000. This could catch large gift transfers.
- Whistleblowers – The IRS can follow up on tips that individuals have made large unreported gifts.
Monitoring direct cash gifts
It can be difficult for the IRS to monitor direct cash gifts since there may not be a paper trail. For example, if you simply withdraw cash from your bank account and gift it to your children, there is no easy way for the IRS to know unless you self-report on a gift tax return.
However, indirect cash gifts are easier to catch. If you pay your child’s $20,000 college tuition bill instead of gifting them money, the IRS can identify that through the school’s financial records if audited. The IRS can also monitor large bank transfers to check for unreported gifts.
Monitoring non-cash gifts
Gifting assets can also trigger gift tax reporting requirements. For example, if you transfer stock shares or real estate to another individual as a gift, you usually have to file a gift tax return even if it is below the $17,000 annual threshold.
When you transfer the legal ownership of an asset as a gift, the IRS considers the fair market value of that asset at the time of the gift. So even if you paid $5,000 for a stock years ago that is now worth $20,000, your gift value to report would be the current $20,000 market value.
The IRS can monitor non-cash asset gifts through:
- Brokerage records for stock transfers
- Property deed records
- Vehicle title transfer filings
In addition, the recipient typically has to report the gift’s value on their taxes when they eventually sell the gifted asset for a taxable capital gain.
How gifts can be used to avoid taxes
The IRS closely monitors gift reporting because large gifts have the potential to avoid gift, estate, and capital gains taxes.
Some ways gifts can be used to skirt taxes include:
- Giving away assets while alive to reduce the taxable estate that will eventually be subject to estate tax
- Gifting property or investments that have built up capital gains to avoid realizing those gains when sold by the recipient
- Not reporting gifts at all and assuming the IRS won’t catch them
That’s why the IRS imposes both gift tax returns and potential gift taxes on large gifts – to limit using gifts simply as a tax avoidance strategy.
Example of using gifts to avoid capital gains
For example, let’s say you purchased stock many years ago for $10,000 that is now worth $500,000. If you sold the shares, you would realize a $490,000 capital gain.
Instead, you could gift the stock to a family member. They can then sell the shares for $500,000 and not owe any capital gains tax since their basis is the full $500,000 value when you gifted it. This avoids the $490,000 capital gain tax you would have owed if you sold the shares yourself.
Of course, you would still have to file a gift tax return for this transaction and it would count against your lifetime exemption amount. But there would be no gift tax owed unless your prior taxable gifts exceeded the $12.92 million lifetime exemption.
Penalties for not reporting gifts
If you fail to file a required gift tax return or underreport your taxable gifts, you may face interest and penalties in addition to any gift taxes owed.
Potential penalties include:
- 5% penalty per month up to a maximum of 25% for failure to file a gift tax return
- 5% penalty for gifts undervalued by more than $5,000
- Negligence penalties up to 20% of unreported gift taxes
- Substantial understatement penalty up to 20%
- Civil fraud penalty up to 75% if deliberate evasion is detected
The IRS gets very concerned when taxpayers appear to intentionally avoid gift reporting. Make sure to fully disclose any gifts you give over the annual exclusion amount.
How to report gifts to the IRS
You report gifts on IRS Form 709 – United States Gift Tax Return. This form must be filed by April 15 following any year that you give more than $17,000 total to an individual.
On Form 709, you must:
- Identify each gift recipient along with their address, Social Security Number, relationship to you, and the gift amount
- Specify whether the gift was made outright or in trust
- Describe the asset gifted including securities details if applicable
- List the asset’s fair market value at the time of the gift
The value listed on Form 709 is critical since it establishes the recipient’s cost basis and counts toward your lifetime gift tax exemption. Work with a tax professional to prepare this form accurately.
When can you make gift tax-free?
There are a few exceptions where you can make large gifts tax-free:
- Spouse – You can give any amount to your spouse gift tax-free
- Charities – Gifts to qualified charities are not subject to gift tax
- Political organizations – Gifts to political groups are considered tax-free
- Medical expenses – Paying someone’s medical bills directly is not taxable
- Education expenses – Paying tuition can be a tax-free gift
However, you still have to report most of these types of gifts over the annual exclusion amount even though no gift tax is owed.
Ways the IRS could improve gift monitoring
The IRS does face challenges enforcing gift tax compliance since gifts often occur in private without documentation. Here are some ideas that could help the IRS monitor gifts:
- Require reporting of all gifts regardless of amount – This would increase paperwork but improve visibility.
- Expand third-party reporting rules to capture more gift transactions such as tuition and medical payments.
- Use analytics to flag unusual bank transfers between relatives that could indicate unreported gifts.
- Require gift disclosures on income tax returns instead of separate gift tax returns.
- Increase audits on high net worth individuals likely to make large taxable gifts.
- Strengthen whistleblower programs to encourage reporting of tax evasion schemes.
However, the need to balance enforcement with privacy concerns means the IRS will likely continue to rely heavily on voluntary compliance for gift tax reporting.
Conclusion
The IRS has visibility into large gifts over the annual exclusion amount through required gift tax returns. But for smaller gifts, the IRS must use audits, third-party reporting, and whistleblowers to identify unreported taxable gifts.
Taxpayers with substantial assets should carefully track gifts they give each year and comply with reporting rules. Proper gift tax planning and compliance can help avoid penalties and enforcement issues down the road.