Net gifts can be used to reduce gift tax rate
By Hook Law Center
An example that reveals the ability of the net gift to save taxes is as follows. A grantor intends to make a $2 million gift to his son. Having used up his gift and estate tax exemption, he would like to reduce the tax. Applying a gift tax rate of 40 percent, if he were to make an outright gift, he would have to pay $400,000 in tax.
However, if his son agreed to pay the tax, there would be a reduction in the value of the gift, and thus, the gift tax liability. The formula that is used to calculate the tax on a net gift is: gift tax = tentative tax / (tax rate + 1). The tentative tax is the amount that would have been owed if the gift had not been arranged as a net gift. In this scenario, the tentative tax is $800,000. An application of the formula to this example results in a gift tax of ($800,000 / 1.4), or $571,429, which represents an effective rate of approximately 28.6 percent.
In order to make certain that his son receives the entire $2 million gift, the father can use a financed net gift. He lends his son $571,429 to pay the tax bill, which bears interest at the applicable federal rate (AFR), and is evidenced by a promissory note in writing.
What if, in this example, the father gave the son real estate with a fair market value of $2 million and a cost basis of $500,000? If the son pays $571,429 in gift tax, the excess of that amount over the father’s basis ($71,429) is a taxable capital gain to the father. You can avoid paying capital gains tax by engaging in a financed net gift transaction with a grantor trust instead of the beneficiary.
When participating in a net gift transaction, the recipient is required to sign an agreement expressing a promise to pay gift and estate taxes upon receipt of the gift. Prior to signing the contract, the recipient is advised to consult an estate planning attorney.