Although the vast majority of Americans have estates that fall under the estate and gift tax exemption, the exemption is set to be cut in half in 2026. Proper planning may be necessary to make sure you are taking full advantage of the current exemption and aren’t negatively affected when it decreases.
The federal estate tax threshold has increased to $12.06 million in 2022. (We'll call it $12 million since when you get to estates of this size, the extra $60,000 is something of a rounding error.) In all likelihood, this is of little concern to you since fewer than 1 percent of households in the United States have assets totaling more than $10 million, and married couples can double these thresholds. So even fewer American families have a net worth exceeding $24 million.
However, this threshold is set to sunset in 2026 to half of its then-current level. Unless Congress acts in the interim, for those dying in 2026 or later the threshold will be $6.03 million (again, we'll just say $6 million), adjusted for inflation between now and then. This sunset raises the question as to what happens if a taxpayer makes a taxable gift before 2026 when the threshold is $12 million or more, but dies after 2026 when the threshold has been cut in half. Fortunately, the IRS has answered this question.
How Gift Taxes Work
The annual gift tax exclusion is $16,000 (in 2022). This means that each year you can give $16,000 to as many individuals as you like with neither you nor the recipient having to report the gifts to the IRS. But if you give anyone more than that amount in a single calendar year, you're supposed to report the excess on a gift tax return. (The recipient still does not have to report it.) It's still very unlikely that you'll have to pay any tax because the gifts are only taxed when cumulatively they reach the $12 million threshold. Instead, they erode how much your estate can pass on tax free.
An example should help clarify this. If you give your brother $1.016 million, you will have to report a taxable gift of $1 million. This means that if you pass away before 2026, your estate tax threshold will be $11 million instead of $12 million. There's still a lot of cushion there, which is why in practice very few people really have to worry about filing gift tax returns.
Pre-2026 Gifts and Post-2026 Estates
But what happens if you die in 2026 or later? Is your effective estate tax threshold reduced to $5 million or is your gift in effect erased because it came under the higher $12 million threshold, still leaving you with a $6 million threshold beginning in 2026?
The answer is that you will get no benefit from the higher threshold because you didn't give enough away. When taxpayers die in 2026 or later, in most cases their estates will be taxed as if the higher threshold never existed. The exception is if they gave away more than the new lower threshold.
So, for instance, if you had been more generous to your brother and had given him $10.016 million instead of $1.016 million and you died in 2026 or later, the $10 million taxable gift would be your new estate tax threshold instead of $6 million. Everything else in your estate would be subject to tax, but the $10 million you gave your brother would still be gift and estate tax-free. In other words, the IRS has ruled that beginning in 2026 your estate tax threshold will be the greater of the estate tax threshold then in place and the total taxable gifts you have made during life.
If you are in that rarified group that may be affected by these rules, don't try taking any tax planning steps on your own. Without proper planning, the estate tax savings may be overwhelmed by the increased taxes on capital gains incurred by the gift recipient. Talk to your attorney before doing anything.