Citizens and residents of the USA are subject to federal taxation on income derived from any source, this includes compensation for services, business and investment income, gains from the sale of property, and income received from an interest in an estate or trust [1]. However, there is an exclusion from gross income for “the value of property acquired by gift, bequest, devise, or inheritance,” but that exclusion does not extend to “the income from” the property per §102 of the Internal Revenue Code (I.R.C.) [2].

This means that the beneficiary of a gift or bequest is not subject to income tax on the value of the property they receive, but they will be taxed on any income subsequently realized from the property (I.E. rental income, or accrued (Earned by the Donor, but received by the Donee) i.e. un-paid interest/dividends). In general this is pretty straightforward in the context of gifts and bequests made to an individual beneficiary. But further details such as the timing, amount, and character of income require a lot more elaboration. The tax treatment of gifts and bequests is complicated because gift or estate tax maybe due respectively, and in the case of bequests, a fiduciary becomes the mediator of the property held in trust or an estate determining how assets will be distributed.

Gift and estate taxes along with the generation-skipping tax are transfer taxes on gratuitous transfers of wealth.

These taxes operate quite independently from the income tax code. At some level they interact in important ways, but in general they are poorly integrated with each other. With an obvious gap in the income tax code excluding the value of property acquired by gift, bequest, devise or inheritance the taxation of gifts and estates was to fill that gap. However in recent years the exclusion and exemptions have made these taxes less impactful to taxpayers.

In general a gift or bequest is a transfer of property but because the transferor (person giving the gift) received no consideration in a legally recognizable form, it’s not treated as a sale or exchange that would be taxed for income tax purposes. So a donor (in the case of a gift) or a decedent (in the case of a bequest made at death) generally do not have to recognize gain or loss upon the transfer of property by a gift or bequest via a will on their personal income tax return, or final income tax return at death respectively.

There is no statutory provision preventing a gift or bequest from being treated as a taxable event. Congress has the power to change this in the future.

In fact there has been proposals to treat a gift or bequest of property to cause the transferor (person giving the gift, or decedent making the bequest at death) to realize gain or loss upon gift or bequest. But these efforts have largely been ignored and this treatment has prevailed for an entire century ( since 1913).

There are several cases where a gift can be treated as a sale or exchange, and you would have a gain.

A common example is if a gift is given that has liabilities attached to it, in excess of the donor’s basis (typically original purchase price). For example, you gift a house you bought for $100,000 in 1980, that has a mortgage of $150,000, and is worth $500,000 in 2022. If you gift that house to your children, with them assuming the mortgage you have a recognizable gain of $50,000, and a gift of $350,000. This is because the Internal Revenue Services views this as though you’ve received partial payment for the property. There would most likely be no realizable gain (Gain on which tax is due) due to IRC 121, which permits a married couple to exclude up to $500,000 in gain from taxable income or a single individual up to $250,000. If you decided to gift only the house, and keep the mortgage (requires approval of the lender), there would be no gain, and it would be considered a full gift of $500,000. What if the house was purchased for $700,000, and there is a mortgage of $550,000 and its fair market value is $500,000? If you gift the house and let them assume the mortgage, it’s a deemed sale of $550,000, and you have incurred a loss on the sale of personal-use property, which is not deductible.

Another example is If the gift is conditioned on whether or not the donee (person receiving the gift) will pay the donor’s (person giving the gift) gift tax liability which is known as a “net gift”. This is because the IRC looks at the intent of the agreement to discharge the transferor of a liability I.E another person agreeing to pay the liability (even if the transferor is in-fact still liable legally).[3]

Lastly, a lifetime gift of an installment obligation is treated as a taxable disposition that then accelerates built in gain in the donor’s hands [4].

• For example: Say Andy sold a Home on an installment sale basis for $60,000, which cost him $30,000, he accepted a $10,000 down payment and an installment obligation at 6% APY interest amortized over 30 monthly payments of $1,795/month.
  
• The face value of the obligation is $1795*30 months =$53,850. The gross profit ratio is 50%, on the principal received each month, the first payment consists of $1,551.98 in principal, and $243.38 in interest. For tax purposes 50% of the principal or $775.99 is realized capital gain taxed at 0%/15%/20%, and the $243.38 in interest is considered ordinary income taxed at the marginal income tax rates.

• If Andy decided to gift his son the installment obligation before receiving any payments, the full unpaid principal balance of $50,000 ($53,850-$3,850)(30 months of interest)) less the remaining income (gain) returnable to the holder of the agreement (50% gross profit margin * $50,000 =$25,000) equals a basis in the obligation of $25,000, any payment in excess of $25,000 will result in a taxable gain to Andy. If the FMV of the note is $50,000 at the time of the gift, Andy would be deemed to have gifted $50,000 to his son, and per IRC 453, would have a deemed disposition with a gain of $25,000 ($50K FMV-$25k basis)

In very rare cases a decedent would realize a gain or loss in property owned at death.

In the case of a Self-Cancelling Installment Note (SCIN) the built-in gain would probably be taxed to the decedent’s estate (instead of the decedent on his or her final income tax return) [5]. However it’s important to note, that legal jurisdiction can come into play in making this decision as the tax court [6], and district courts have been at odds as to what I.R.C. section is the controlling provision as two of them are at odds with each other.[7]

The exemption for gifts is indexed to inflation and for 2022 is $16,000 per person (per spouse) or $32,000 per person for a married couple (gift splitting).

In terms of gift tax exemptions, for 2022 it’s possible to gift to individuals or businesses up to $16,000 with no gift tax return requirement. However, gifts of future interest below the exemption(s), or gifts in excess of $16,000 or a married couple who is gift splitting up to $32,000 would need to file a United States Gift (and Generation-Skipping Transfer) Form 709. A married couple may not file a joint gift tax return. Should a married couple decide to split gifts, they would each need to file separate gift tax returns.

Gifts in excess of the yearly inflation indexed gift tax exemption, are taxable to the extent the taxpayer doesn’t utilize their lifetime GST exemption, for 2022 this exemption is $12.06 Million.

You are not required to allocate your available lifetime exemption. You may allocate some, all, or none of your available exemption, as you wish, among the gifts you make for that year. If you do not allocate your exemption, you will be subject to gift tax rates.

2022 and 2021 Federal Gift Tax Rates

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This article is not professional tax or legal advice for your specific circumstances. Consult with your professional adviser to better understand how these items may impact you, or how they’ve changed

[1] I.R.C §61 (a)

[2] I.R.C. §102(a)

[3] Reg. 1.1001-2(a) & (c) (example 6) & Diedrich v. Commissioner, 457 U,S, 191 (1982)

[4] I.R.C. §453B(a)

[5] I.R.C. §453B (c) and (f)

[6]Estate of Frane v. Commissioner upheld unrealized gain is reported on decedents final Form 1040

[7] United Stats Court of Appeals for the Eight Circuit reversed the Tax Court holding on the issue, and held that the gain is reported on the estate tax return, on the theory that I.R.C 691(a)(2) and 691(a)(5) are controlling provisions.