Gifting and the Corresponding Taxes

One of the more confusing areas for clients wishing to share financial gifts with their children and grandchildren is taxes. When it comes to gifts, there are two relevant tax systems: gift taxes and income taxes. While most gifts are not taxable to the recipient, gifts of appreciated assets do come with embedded gains that would trigger an income tax paid by the recipient.

Technically, the IRS considers gifts to be taxable to the giver (for estate tax purposes). Each year, the IRS sets an “annual gift exclusion” amount that allows gifts at or below that amount to be gift-tax-free. Generally adjusted annually for inflation, in 2026 that amount is $19,000. Any person can give any other person $19,000 without either one needing to report it on a gift tax return or income tax return. That means a couple could give each of their children a combined $38,000 this year. If they want to increase the amount to, say, help with a down payment on a house, they could give a son-in-law or daughter-in-law $38,000 as well. However, if that couple wants to give the kids more than that, it becomes subject to gift (also referred to below as “transfer”) taxes.

At the federal level, the gift tax rules are integrated with the estate tax rules to create the unified gift and estate “transfer tax” system. Currently, each person has a lifetime transfer exemption of $15 million, which means he or she can give away up to $15 million during his or her lifetime or at death. If dad gives his daughter $500,000 to buy a house – and that is the only gift he has made above $19,000 to anyone throughout his life so far – he has $14.5 million of gift/estate exemption remaining. If he passes away with an estate worth $10 million, he is below his remaining $14.5 million. Current law adjusts the unified lifetime gift and estate exemption amount for inflation each year. If current law remains in place when dad passes, there is no gift or estate tax owed. However, if he gifts more than the lifetime exemption amount during his lifetime – or the combined total of his estate and lifetime gifts are above the exemption amount at his death, “transfer” taxes will be owed by the estate – up to a maximum of 40% on the amount above $15 million.

One solution that can be employed to mitigate these transfer taxes is to make sizable gifts out of the estate via various estate planning techniques. One of the more basic ways is via a gift trust. As an example, let’s say mom & dad have worked with their advisor and know that there is an extremely low probability that they will need $500,000 of their portfolio for themselves and their own lifetime needs. They decide to give that $500,000 to an irrevocable gift trust with their son as beneficiary and file the required gift tax return. Assuming the funds are fully accessible to the son (or other applicable paperwork is completed), this is a “completed gift” that removes the $500,000 from mom and dad’s estate and reduces their remaining lifetime exemptions. There is no income tax owed by mom, dad or son on that gift. If cash is gifted, the trust will owe income tax on future annual portfolio income. If appreciated investment positions were gifted, it is important to understand that mom and dad’s original cost basis follows those positions. If the trustee sells them so that the son may effectively spend the gift, the trust will owe capital gains taxes (a form of income tax) on the difference between the sales price and the cost basis.

There are various additional techniques that may be used to shift these taxes out of the compressed fiduciary (trust) tax brackets to either mom and dad or the son, but the primary point that many do not fully appreciate is that the original cost basis follows the gifted positions and remains with it forever. While mom and dad have effectively transferred the growth of the $500,000 out of their estates, unlike assets in mom & dad’s estates in which the original cost basis is “stepped-up” to the value as of date of death (effectively wiping out capital gains to that date), any assets in the gift trust do NOT receive that step-up.

While there are additional complex legal and financial strategies that may be used to offset some of the impact, it is important to work with your advisor to understand the full picture of the tax consequences across generations when trying to optimize for estate and income taxes – especially if that is the sole reason for making the gift. There are plenty of other great reasons to utilize various irrevocable trust strategies, but many do not realize that they do not always result in meaningful tax savings when including combined income and transfer taxes across the generations. We invite you to share this article with others who may also find it useful.

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