Gift tax implications of generosity

An act of generosity comes from a good place. Perhaps it’s to support a family member or treat a friend. Receiving something in return is often not part of the equation. After all, that would defeat the purpose. With positive intentions guiding you, it’s understandable that gift tax implications might be far from your mind. You may be unaware that tax obligations may result from use of personal property that may seem innocuous. If you have recently allowed someone to use your property, it is worth considering whether you have inadvertently made an unreported gift.

The Supreme Court back in 1984 held that an interest-free loan is a gift but did not hold that personal use of property is a gift. Also, Congress codified the interest-free loan rules after that Supreme Court decision but did not legislate that the rent-free use of property was also a gift. Those differences may result in misinterpretation of rules, especially those governing use of property, so it’s crucial to understand the unintended gift tax implications that can arise from your generosity.

The IRS assesses a gift tax on “the transfer of property by one individual to another while receiving nothing, or less than full value, in return.” This definition encompasses numerous gifts that may not initially appear to significantly affect your gift tax reporting.

To be clear, simply making a gift does not mean you will owe gift tax. In 2023, each taxpayer has $12.92 million of lifetime exemption available to use during life or at death to transfer assets tax-free to others. This use-or-lose exemption is scheduled to drop on Dec. 31, 2025, to about $7 million, indexed for inflation.

In addition to the lifetime exemption, there is an available gift tax annual exclusion under which gifts of a present interest (meaning the recipient can enjoy it today) worth $17,000 or less per donee in 2023 ($34,000 if splitting gifts with a spouse) do not utilize any of your available lifetime exemption. Knowing how much lifetime exemption you have used during life, intentionally or unintentionally, is critical for estate planning purposes.

By understanding the tax implications of various acts of generosity, you can manage your lifetime exemption and avoid costly surprises. Here are five acts that the IRS could or will consider taxable gifts, and how you might plan for them.

1. Treating your family and friends to a vacation

You may cover the expenses for a lavish vacation along with certain expenses, such as air travel, for your friends and family. If you pay for the expenses and do not receive the full value in return, the expenses paid may be treated as a gift to anyone who attended the trip. You may have to file and report these gifts on your gift tax return if the total per donee is more than the annual exclusion that year, including other gifts made to the same individuals.

2. Paying for someone else’s expenses

You may want to help a friend or family member by supporting or covering some of their expenses. Any money you give directly to another individual, even if for medical or educational expenses, will be treated as a gift. Further, if you pay a credit card bill on behalf of another person, that would also be treated as a gift. 

3. Letting someone live in your home rent-free

In general, if you allow someone to use your property for free or for less than its fair market value, a gift may have occurred. Certain familial use of property may not be considered a gift and, generally, allowing someone to use a spare bedroom in your personal residence likely would not be treated as a gift. However, allowing someone to use your commercial property for free likely would be treated as a gift.

For example, if your friend lives in a second residence that you own and pays either no rent or rent significantly below the fair market rental value, you may be treated as making a gift that is equal to the fair market value rent. This could apply to anyone who allows a child, sibling or parent to occupy a residence on a rent-free basis, which can become a large gift fairly quickly and trigger a gift tax return filing.

For 2023, the annual gift exclusion is $17,000. If the monthly fair market value rent is greater than about $1,400, then you may need to file a gift tax return to disclose the gift to the lessee and track the use of your lifetime exemption. If any additional gifts were given to the same individual throughout the year, that filing threshold could be reached much sooner. 

4. Allowing someone to use cherished personal property

A gift of property occurs when you transfer ownership in the property to someone else, and you either do not receive any consideration in return, or you receive less than the full value of the property. The use of personal property may also be considered a gift. Some examples include allowing the use of cars, houses, yachts, jewelry and art. A gift occurs even if you gift partial ownership in such property.

When you give property to a donee in excess of the annual exclusion, you will need to file a gift tax return to report the property given. For example, a parent allowing their child to use their car during the summer likely would not be treated as a gift. On the other hand, a parent purchasing a car and changing the title to the child’s name would be treated as a gift. 

5. Forgiveness of indebtedness

You may enter into loan agreements with family members and friends. These loans are typically structured with interest rates, repayment terms and the intent that the maker will be repaid. However, you might choose to forgive the interest or principal of the loan, in whole or in part. Other scenarios include loans that are either interest-free or the interest is below market. When you forgive interest or principal, the amount forgiven will need to be reported as a gift on your gift tax return unless the amount forgiven is less than the annual exclusion (considering other gifts made to the same individual). If you have entered into a below-market or interest-free loan with someone, there likely will be gift tax consequences as well. 

Forgiveness of indebtedness could be a planning technique to help a friend or family member. Forgiving amounts less than the annual exclusion each year may allow you to forgive debt without using any of your lifetime exemption. A prearranged plan to forgive amounts less than the annual exclusion each year may result in the IRS arguing that the entire gift occurred in the initial year. Make sure you use a proper interest rate when entering into loan agreements to avoid additional unintended gifts. There may also be income tax consequences with these types of transactions.

Taxpayer takeaways: Good outcomes from good intentions

Seek advice from your tax professional about whether acts of generosity come with gift tax reporting requirements. While you may perceive your actions as simply a helping hand, the IRS may view certain assistance as a reportable gift.

Your tax professional and estate planning attorney can ensure you have properly reported your lifetime gifts. Knowing how much of your lifetime exemption has been used for prior transfers allows you to move forward with a full understanding of what remains for future gifting.