LOS ANGELES (MarketWatch) — The IRS expects a potential windfall in gift tax compliance audits in California and has asked the U.S. District Court for what amounts to a virtual blank check to see the tax-free property transfers in the State Board of Equalization’s database for 2005-2010. In a state where real estate can be transferred to family members without triggering a property tax increase, there’s a ready-made database for IRS to examine.
Since these were tax-free transfers, why should this interest the IRS at all? The IRS believes there is a bonanza of unfiled gift tax returns on these transfers of homes and other properties.
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While family members in California may transfer personal residences and up to $1 million of other real estate without triggering a property tax increase, gift tax returns need to be filed. But were they? If not, this fishing expedition can result in some hefty gift taxes, penalties and interest.
What is the IRS likely to find?
Many of those transfers will be to living trusts or other revocable grantor trusts, which don’t trigger gift taxes. They are simply used to avoid probate costs and delays upon the owner’s death. Another large segment of the database will be transfers of properties worth significantly less than $1 million, owned by individuals or couples with estates whose values will never approach $1 million dollars. In which case, even if gift tax returns had been filed, the lifetime exclusion would eliminate any gift taxes.
However, the IRS is apt to find some serious money. Why? After all, wouldn’t people with million-dollar properties be consulting attorneys? Certainly. But they would be working with real estate attorneys or their business attorneys. When a tax or estate attorney, CPA or Enrolled Agent is not involved, the income tax, estate tax and gift tax filings and considerations may be overlooked.
You don’t live in California, why should you care?
The IRS is after money. We have a budget deficit of nearly $1.5 trillion and a tax gap of $290 billion. Without raising taxes, where can the country find money? By getting better at enforcing laws already on the books.
In states with large cities such as New York City, Chicago or Boston, home values easily exceed a million dollars. When IRS succeeds with this audit project in California, expect them to visit your state, too.
Basics about gift tax limits
You may give any one person up to $13,000 in total gifts without filing a gift tax return (from 2009 – 2011). This limit includes all gifts for the year, not just money or property. It includes birthdays, graduations, holidays, etc. (The limit was $12,000 from 2006-2008; $11,000 from 2002-2005.)
For 2011 to 2012, the lifetime exclusion from gift taxes has risen to $5 million. During the 2005 to 2010 period, the lifetime exclusion on gifts was only $1 million dollars. Gift tax rates for taxable gifts have ranged from 47% in 2005, to 35% currently. Barring new legislation, the gift tax exclusion will revert to $1 million in 2013, with a tax rate of 50%.
How can you avoid getting caught in the IRS’ gift tax compliance trap?
Look back at any properties or assets you changed title on in the past five years for any reason.
If you transferred assets, or parts of assets, to anyone at all, make sure a gift tax return, Form 709, was filed, when needed. Married folks must each file a separate Form 709. There is no such thing as joint Form 709.
You can avoid gift tax returns altogether if the asset’s value was less than the annual limit. If the asset value was higher, there are still ways around the gift tax. But you will have to file the gift tax return.
Filing the Form 706 to generate no taxes
You or your spouse can give property worth more than $13,000, but less than $26,000 to each of your offspring or grandchildren. There’s a technique called “gift splitting” where you report part of your spouse’s gift to someone as your gift. IRS explains it in more depth, in chapter 2 of Publication 950.
For instance, you give your nephew $20,000 and your wife gives her sister $18,000. Separately, each of you has exceeded the annual $13,000 limit, right? But, each of you can file a gift tax return reporting half of each gift. It looks more like this:
You gave your nephew $10,000 and your sister-in-law $9,000.
Your wife gave your nephew $10,000, and her sister $9,000.
Discounting is another technique. Bill Fleming, managing director of PwC in Hartford, Conn. explains how to use this when you give someone a partial interest in a property. You can get an appraisal showing a lower value because the recipient of the gift doesn’t have full control of the asset or property. You must still file the gift tax return, but using the lower values will cause you to deplete your exclusion more slowly.
For instance, you give your best friend 10% of a rental property worth $2,000,000. At face value, that gift would be worth $200,000. But he cannot sell his interest without your approval. In fact, he might become responsible for out-of-pocket expenses, without the power to veto those repairs. An appraiser might value his share at only $150,000. How does that affect the gift tax?
You have a tax-free gift of $13,000.
The other $137,000 reduces your $5 million lifetime exclusion to $4,863,000.
You pay no gift tax
Not using discounting would have reduced the lifetime exclusion by another $50,000. This isn’t so important with a $5 million limit. But with $1 million, this added up quickly.
This concept can be particularly important when you are going back to transactions from several years ago that actually generate a gift tax. The more restrictions there are on the title or authority to control the asset, the larger that discount will be. Considering a 2005 gift tax rate of 47%, every dollar counts.
These concepts barely brush the surface of the gift-tax issues. When you are making plans — instead of trying to prepare unfiled gift tax returns — you can play with a variety of trusts, charitable contributions and other gifting ideas.
After years with a lifetime gifting limit of $1 million, we are experiencing a few years with $5 million as the lifetime limit: 2011 to 2013. This is the time to do some planning. Fleming warns that the gift exclusion limits may not always be this high. Gifting and estate planning go hand-in-hand. Read TaxWatch next week for some tips on estate planning.
Eva Rosenberg is the founder of TaxMama.com and an enrolled agent licensed to represent taxpayers before the IRS. Visit her new website at www.TaxMama.com