Are Gifts to Children Tax-Deductible?

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I’m often asked if someone can take an income tax deduction for money they gift to their children. Gifts to individuals are not tax deductible. Tax deductions can only be taken for gifts to organizations on the IRS list of approved charities. However, there is a way to get a partial deduction for money that will eventually go to your children. A charitable lead annuity trust (CLAT) gifts money to a charity first, and then passes assets to your beneficiaries.

Assets gifted to a CLAT are used to make annual payments to a charity for a specified term. At the end of the term, money remaining in the trust goes to the beneficiaries free of estate and gift taxes. The concept is to distribute the entire principal plus a minimum rate of return to the charities. The rate of return is defined by the applicable federal rate (AFR) that is published monthly by the IRS. The most recent AFR for long-term contracts was 2.76%. The beneficiaries receive the growth of the trust that exceeds the AFR. Therefore, the trust assets need to be invested in a manner that allows them to generate excess growth for the beneficiaries.

The donor receives a charitable deduction equal to the present value of the charitable payments based on the AFR. For example, a donor gifts $1 million into a CLAT that makes annual charitable payments over 20 years. The donor would receive an immediate deduction of about $250,000 based on the current AFR. The charity would receive more than $1 million in payments during the term of the CLAT, and the beneficiaries would receive the remaining principle. An average return of 7 ½% would allow the trust principle to maintain the $1 million original value for the beneficiaries.

There are drawbacks to using a CLAT. One drawback is that the income earned in the CLAT during the term is taxed to the donor. You should seek the council of an experienced financial adviser or estate planner to determine if a CLAT is appropriate for your goals.

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