Inheritances and gifts often seem paired ideas, attached almost magnetically by the opposing emotions of grief and joy. When clients call me to discuss them, the first part of the conversation invariably involves condolences on the death of a loved one, or congratulations on the betrothal, birth, or house purchase. After that, my clients usually ask, “How much income tax am I going to have to pay on this?” They are generally surprised when my answer is, “None.”

Not all receipts of money or other valuable assets are income. First, the asset must be unconditionally yours in order for it to be income. Loan proceeds are not income because you have to pay it back. Second, income requires a reciprocal transaction. You perform services, and your employer pays you. You deposit money in a bank, and they pay you interest. You put a quarter into the slot machine, and it spews out $5,000.

Inheritances and gifts are not reciprocal transactions. You can honor the memory of the deceased in many ways (visiting the grave, saying kaddish, making memorial contributions), but the road to that “undiscover’d country from whose bourne no traveler returns” is decidedly a one-way street. And gifts are, well, gifts: They merely reflect a generous impulse from the donor.

Castor and Pollux

Income taxes are not the only form of tax. Gifts and bequests are potentially subject to other federal and state taxes. Here, too, they are closely linked. Estate taxes and gift taxes are really one unified tax, at least at the federal level, differing only in how they are reported to the Internal Revenue Service. A gift tax return must be filed for any year in which one makes a taxable, or potentially taxable, gift. Metaphors aside, one dies only once, so estate tax returns are strictly one-per-person. 

Gift and estate taxes, if any, are paid by the donor or the estate. The amount you receive is not affected unless, of course, your bequest is the residual estate, that is, whatever is left after taxes are paid.

“Potentially” and “if any” are scattered in the last couple of paragraphs because there are some good-sized exemptions from these taxes. To start with, anyone can give anyone else up to $11,000 per year without gift tax liability, or even having to file a form. This exclusion applies to each specific combination of donor and donee, so families can leverage this to cover much larger sums. For example, your father can give you $11,000 and your spouse $11,000; so can your mother, for a total of $44,000. If they want to do more than that (say, for the down payment on that first house), they can lend you the rest and forgive $44,000 of that debt on the next New Year’s Day, though you will have to pay the interest.

Additionally, tuition payments made directly to the school, and medical expenses (including insurance premiums) paid directly to the provider are excluded from taxable gifts.

Beyond that, each person has a lifetime exemption that can be used against either gift or estate taxes. Currently, it is $1 million. Gifts above the annual exclusion amount must be reported each year, but no tax is due unless and until the lifetime exemption is used up. Whatever part of the exemption is not used for gifts is applied to the estate, and only the excess is subject to tax.

The lifetime exemption rules change next year. The amount remains $1 million for gift tax, but increases to $1.5 million for estate tax in 2004, $2 million in 2006, and $3.5 million in 2009. As the law now stands, estate and gift taxes disappear in 2010, but reappear in 2011, with a lifetime exemption of a mere $625,000 and higher tax rates. (Please just accept this bizarre fact. The arcana of estate and gift taxes are like the finer points of particle physics: Neither is really comprehensible by a lay person.)

Beatrice and Benedict

The difference between a gift and a bequest can have hefty tax consequences when the transferred asset is sold.

Consider an asset that you bought and later sold. In the simplest case, like a stock or a diamond, you determine your profit or loss by subtracting the cost of the asset from its selling price.

But if the asset was a gift or a bequest, you have no cost. Income tax law addresses this by using the term basis (as in “basis for calculating gain or loss”). The basis of an asset received as a bequest is the value on the date of death (or, in rare circumstances, a date six months later). But the recipient’s basis in an asset received as a gift is the donor’s basis. This can lead to some interesting adventures in cost tracing, as when you sell the stock that your long-deceased grandmother gave you 30 years ago.

In my neighborhood are many older folks who bought their homes fifty years ago for, perhaps, $10,000; even as tear-downs, these houses are now worth $500,000. If they give the house to their adult children, who sell when the parents die, the kids have a taxable capital gain of $490,000; if, instead, the children inherit the house and then sell it, their taxable gain is zero. Amazingly enough, some parents still think they are doing their kids a favor by signing over the house when the parents’ health starts to fail. They may be simplifying their estate, but administering a complex estate is much less costly than the tax on $490,000.

Are there money or tax questions you would like to see discussed in this column? Let me know, at 2835 N. Sheffield, Suite 311, Chicago, IL 60657, or call 773/525-1778 (888/525-1778 toll-free outside the Chicago area) or e-mail greg@gregmermel.com.

Greg Mermel is a certified public accountant whose clients in the arts range from individual performers to major theatre companies and suppliers. He also sometimes produces theatre.

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