Navigating Gift and Estate Tax Audits

Gifting money, real property, or other valuable personal property to friends or family members seems like a good idea and a great way to avoid income tax issues. For tax purposes, gifts are not taxed, at least at first, and gift-givers only pay taxes on very large gifts. However, as with anything involving taxes, it’s not quite that cut-and-dried.

If the gift is not reported by the gift-giver, the property value exceeds the annual exclusion amount, or the item given was not a “gift” under IRS guidelines, then the recipient may wind up paying taxes on the gift after all. This article explains the gift pitfalls you need to avoid to stay on the good side of the IRS.

The High Cost of Free Money (and Other Gifts)

What is a gift? According to the IRS, a “gift” has an objective legal definition. It doesn’t matter what the giver’s intention was. A gift exists when:

• A taxpayer transfers any property for less than “full and adequate consideration,” meaning for less than the value of the property
• The giver cannot take the gift back
• The recipient can do whatever they like with the property without reservation

Parental guilt-trips notwithstanding, if a parent gives an adult child a house or pays their student loans, it is a gift if the parent has no legal standing to rescind the title or the money.

Gifts trigger gift taxes when the value exceeds the annual or lifetime federal exclusion limit. These exclusion limits change regularly. For the 2026 tax year, the annual taxable limit is $19,000. The lifetime federal estate tax exemption in 2026 is $15 million per individual. Gift-givers must report any gifts over the annual exclusion limit on Form 709 and pay the gift tax liability associated with the value of the gift if the giver exhausts their lifetime exemption.

Gifts below that amount do not trigger the federal gift tax. There are other exclusions, such as gifts between spouses, tuition and other education payments paid directly to the school, and medical expenses paid directly to a medical group.

Capital Gains Taxes and Other Taxes

The gift-giver pays taxes when they make the gift. The recipient pays taxes if they sell or otherwise profit from the gift. The IRS assesses the capital gains tax on the value of the property at the time of the sale, not at the time of the gift. Gifting real estate means the donor pays a gift tax today, but the recipient pays a capital gains tax on the property if and when they sell.

Let’s use an example. A giver buys an asset for $50,000. This is their cost basis. Later, the giver gives the asset to the recipient. At the time of the gift, the asset’s fair market value had risen to $120,000. With a cost basis of $50,000 and a sale price of $120,000, the recipient will owe capital gains tax on the $70,000 of appreciation (the difference between the sale price and the cost basis).

However, if the same person inherits the same item with a fair market value of $120,000, the recipient receives it with a stepped-up basis. The stepped-up basis is the fair market value at the time of the giver’s death. Under the stepped-up basis, there is no capital gains tax if they sell it shortly thereafter, since they inherit the item at its current fair market value. If they hold on to the gift, any appreciation beyond the stepped-up basis may be subject to capital gains tax.

This valuation applies to real estate, stocks and bonds, and some types of art and valuables. Gift and capital gains taxes are ways the IRS ensures no one avoids taxes by passing property around as gifts.

The estate tax, paid from the decedent’s estate prior to distribution of the estate, and any state inheritance tax paid by beneficiaries after they receive their inheritance, are separate from capital gains and gift taxes. In states with inheritance taxes, the tax is calculated by the fair market value of the property at the time of the original owner’s death.

When the Giver Has To File: Form 709

When a person gives a gift over the statutory value, they must report it by filing Tax Form 709 between January 1 and before April 15 of the year following the year of the gift. The giver uses this form when the total gifts to any single recipient for the year exceed the statutory amount. Other gifts that appear on a Form 709 include:

• Future interests regardless of the amount
• Gifts of community property (each spouse must file a gift form)
• Forgiveness of debt
• Digital transfers

A generation-skipping transfer tax is a type of wealth tax that the IRS uses to prevent large transfers from “skipping” taxes by bequeathing property to beneficiaries two generations away from the grantor. For instance, if a grandparent bypasses their children and gives property to their grandchildren, this would trigger the generation-skipping transfer tax.

This tax applies when:

• A gift or transfer goes directly to a so-called “skip person”
• A taxable distribution of funds goes from a trust to a “skip person”
• Taxable terminations occur when an interest in a trust terminates, and the only remaining beneficiaries are “skip persons”

Sooner or later, the IRS is going to get its share.

Long-Term Consequences of Failing to File

The short-term consequences of failing to file Form 709 are the same as not filing any tax return. You may face late filing penalties, interest charges, and possible fraud allegations.

The more serious consequences involve the statute of limitations. The IRS has a three-year statute of limitations to audit a tax return, and ten years from the date the return was due to file charges. A gift tax has no due date, and thus no start time for the statute until you file. Failing to file your gift tax form means the IRS can assess penalties whenever it learns of the gift.

Your heirs or the gift recipients may also have tax liability issues later if they sell or transfer the property. They could face assessments for gift and capital gains taxes, creating more confusion and headaches down the road.

If you are unsure about your gift tax filing, consider getting legal assistance from a qualified tax attorney. They can guide you through the correct way to gift property, keep your taxes low, and still stay on the right side of the Internal Revenue Service.

When a Gift is Not a Gift

When you file your income tax return and include your gift tax return and other exemptions, the IRS can still decide that some of your legitimate sales are instead taxable gifts. One of the most common examples is a parent selling a house to their child for a price well below market value. A homeowner may take a loss on their property if they wish, but they must still show that the transaction meets the requirements of a valid sale.

A transaction is a “gift” for gift tax purposes if you received less than fair market value, despite your intentions for the transfer. You can still prove it was a sale, but you may need legal assistance. The IRS will send a notice of audit giving you time to respond. Do not ignore this notice. You should contact a tax attorney at once.

Your attorney can explain what you need to prove the transaction was a bona fide sale. If it were a transfer to a family member, it could be a “gift of equity,” that is, a part-gift, part-sale. You will still need some or all of these documents:

• For real estate, an appraisal showing the fair market value
• A sales contract showing proof of “arms-length” negotiation and the agreed-upon price
• Proof of payment, such as bank records or receipts showing you actually received some type of payment
• For a real estate transaction, you’ll need the closing statement

You may need to file an amended Form 709 and pay additional taxes on the “gift.” Your attorney can explain what you need to do when contacting the IRS.

When You Need An Attorney

If all this seems very confusing, that’s because it is. Tax law is complex and murky at best. The Internal Revenue Code is hundreds of thousands of pages long. To understand the best way to give a gift or ensure your beneficiaries pay the minimum estate tax, getting legal help is always a good option.

An attorney does much more than just review your tax returns or call the IRS on your behalf. You should discuss your estate planning with an attorney to ensure that any trust distributions do not exceed the annual exemption amount. If you are facing a gift or estate tax audit, consult with your attorney before making any other calls.

It is not illegal to structure your gift-giving in ways to reduce the taxes you or the recipient must pay, but you should talk to your attorney or a tax professional before doing so. An attorney can help you avoid tax court before the IRS sends you a notice of deficiency. Some tips your attorney might suggest:

• Gift splitting: Married couples can give the same individual gifts up to their own annual exclusion amount. The tax is triggered by the giver, not the recipient. In 2026, two parents could give one child $19,000 each for a total of $38,000, and neither would pay a gift tax.
• Gifts to spouses: If your spouse is a U.S. citizen, you can give them unlimited gifts without triggering the exclusion amount. There are some exceptions for terminable interests.
• Trusts: If you plan to make long-term donations to an individual, a trust is preferable for both of you. An estate planning attorney can explain how to set up a trust so the beneficiary receives payments rather than trying to navigate the lifetime gift exemption.

Whenever you consider giving gifts to family, friends, or institutions, speak to your tax attorney or other financial professional. Unless done properly, transferring money or property can lead to an unpleasant surprise at tax time for you and the recipient.