Net gifts can be used to reduce gift tax rate
One strategy to lower your taxable estate is lifetime giving. However, there is a gift tax rate of 40 percent. If you have exhausted your $5.43 million gift and estate tax exemption, and you wish to lower your gift taxes, consider the possibility of making net gifts. This method obligates the recipient to pay the gift tax as a condition of accepting the gift, thereby lowering the value of the gift for gift tax purposes.
An example that reveals the ability of the net gift to save taxes is as follows. A grantor intends to make a $2 million gift to his son. Having used up his gift and estate tax exemption, he would like to reduce the tax. Applying a gift tax rate of 40 percent, if he were to make an outright gift, he would have to pay $400,000 in tax.
However, if his son agreed to pay the tax, there would be a reduction in the value of the gift, and thus, the gift tax liability. The formula that is used to calculate the tax on a net gift is: gift tax = tentative tax / (tax rate + 1). The tentative tax is the amount that would have been owed if the gift had not been arranged as a net gift. In this scenario, the tentative tax is $800,000. An application of the formula to this example results in a gift tax of ($800,000 / 1.4), or $571,429, which represents an effective rate of approximately 28.6 percent.
In order to make certain that his son receives the entire $2 million gift, the father can use a financed net gift. He lends his son $571,429 to pay the tax bill, which bears interest at the applicable federal rate (AFR), and is evidenced by a promissory note in writing.
What if, in this example, the father gave the son real estate with a fair market value of $2 million and a cost basis of $500,000? If the son pays $571,429 in gift tax, the excess of that amount over the father’s basis ($71,429) is a taxable capital gain to the father. You can avoid paying capital gains tax by engaging in a financed net gift transaction with a grantor trust instead of the beneficiary.
When participating in a net gift transaction, the recipient is required to sign an agreement expressing a promise to pay gift and estate taxes upon receipt of the gift. Prior to signing the contract, the recipient is advised to consult an estate planning attorney.
The elder law attorneys at Hook Law Center assist Virginia families with will preparation, trust & estate administration, guardianships and conservatorships, long-term care planning, special needs planning, veterans benefits, and more. To learn more, visit https://hooklawcenter.com/ or call 757-399-7506.