Gifts of Money Not Always Taxable
Q. Will you please explain how the gift tax system works and what its rationale is? I gave my grandson $15,000 to buy a car. I consider it a personal expense, and it was made with after-tax money; it was not a deduction. So why the gift tax? Isn’t this double taxation?-- D.C .
A. First, let’s explain what the so-called gift tax is really all about.
Our current tax system essentially treats the transfer of wealth--up to $600,000 a person--the same whether the transfer was made during the donor’s lifetime or posthumously. Taxpayers are permitted to give away up to $600,000 during their lifetimes, or after death, without either the recipient or the donor owing any tax on that transfer. (Of course, this money has already been subject to taxation once, for the year it was accumulated.)
Once the $600,000 limit is crossed, donors are liable for taxes--you’re right, this is now double taxation--on the amount in excess of that maximum. Tax rates start at 37% and are graduated up to 55% (on $3 million). These limits and rates are the same, whether the gift is given during the donor’s lifetime or not. If a gift comes after death, the donor’s estate pays any applicable taxes.
Now to your gift. Remember, all taxpayers are allowed to give away up to $600,000, tax-free, in their lifetimes or at death. In addition, each of us may give any other person up to $10,000 a year over and above that limit. Two-thirds of your $15,000 gift to your grandson--$10,000--is covered by that annual gift provision. The remaining $5,000 counts against your $600,000 lifetime limit.
You must file gift tax Form 709 with your income tax return, but you owe no tax on that gift, unless--and this is unlikely--you have already given more than $600,000. Once you file Form 709, the government notes that your remaining exemption stands at $595,000. The same process is followed every time you exceed the annual $10,000 per-capita limit. Then, at your death, any bequest beyond the remaining limit is subject to taxation.
Deducting Losses on IRA Accounts
Q. In a recent column, you said that taxpayers are allowed to deduct losses on after-tax contributions to individual retirement accounts. Can you explain the rules governing these deductions?-- R.A.C .
A. The Internal Revenue Service has established strict guidelines governing the deductibility of losses sustained by after-tax IRA investments. It wants to prevent abuses and ensure that Uncle Sam gets his full share of tax-deferred retirement savings.
Under these guidelines, taxpayers must, in essence but not in reality, aggregate all their IRA investments--pretax as well as after-tax--to determine if their IRA withdrawals add up to less than the total tax basis of all the accounts.
Furthermore, a deduction is not allowed until all the accounts--pretax as well as after-tax--have been fully depleted.
Deferring Tax on Land Sale
Q. I have 7.5 acres that I want to sell. Must I reinvest my proceeds in more land to avoid a big tax hit? What are my choices? C.R .
A. To defer taxes on your immediate gain, you may enter into what is known as a Section 1031, or Starker, exchange. This program, explained in Section 1031 of the Internal Revenue Code, extends to investment property the same tax-deferral benefits that homeowners enjoy. The program allows you to roll over your proceeds into any type of real estate within a prescribed period of time. You would be wise to consult a real estate attorney or accountant for professional advice before proceeding with an exchange.
Installment Sale: You Pay Now and Later
Q. I am thinking of selling a piece of commercial property I purchased five years ago through a 1031 exchange. I estimate that at the net sales price we are considering, $610,000, I will have a gain of about $93,000. The sale proposal calls for the buyer to assume our first-trust deed of $375,000 and for me to take back a second deed of trust of $225,000.
The buyer’s $150,000 down payment will go toward reducing the first deed by $100,000, to $275,000, and closing costs. I will not be realizing any cash out of the sale until the note is paid off, in three to five years. When do I have to pay taxes on my gain--now, or when I get the cash from the note?-- P.M.L .
A. This deal is an installment sale. You are liable for taxes now on a portion of the sales proceeds, and you will be responsible later for taxes on the remainder as you receive it. Here’s how to figure it all out, a process you will re-create when you complete IRS Form 6252:
First, calculate your gross taxable gain by deducting your tax basis, as adjusted by improvements and depreciation, from your net sale price. You say your figure is $93,000. Then you must calculate what percentage of the deal this profit represents compared to your initial investment. This is done by dividing your gain, $93,000, by the contract sale price. (The latter is calculated by subtracting the debt relief of $375,000 from the net sale price of $610,000, yielding $235,000.) This gives you a ratio--or what the IRS calls your “gross profit percentage”--of 40%.
To determine how much you owe the government for the year of sale, you apply 40% to the down payment of $150,000, meaning $60,000 of the down payment is a taxable gain and subject to the maximum 28% capital gains tax. The same 40% of all future repayments of principal will also be subject to capital gains tax. The remainder is considered a return of your investment and is not taxable. Of course, any interest payments you receive on the second trust deed are all taxable.