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The pros & cons of reporting gifts to the IRS

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We usually don’t advise adding to the staggering tax paperwork you’re already required to fill out. But sometimes, it makes sense to submit “extra” forms and schedules, just to be safe.

Strategy: File the federal gift-tax return—Form 709—for gifts you made this year, even if you’re not required to. Under recent tax-law changes, the filing can protect your family if the IRS starts digging for dirt later.

You’re required to file Form 709 by April 15 of the following year if your total gifts for the year exceed the annual gift-tax exclusion: $12,000 per recipient for the 2006 tax year.

If you and your spouse make a gift jointly, the exclusion doubles, to $24,000 per recipient. (You generally need to file a gift-tax return for joint gifts. But if you live in a community-property state, you don’t have to file on joint gifts up to the $24,000 limit.)

Of course, you can avoid paying any tax on excess gifts through your lifetime $1 million gift-tax exemption. But using this exemption could erode your estate-tax shelter for other assets. With the future outlook for federal estate tax still cloudy, you might not want to run the risk.

Some taxpayers have faced this quandary: If they understated the value of lifetime gifts, they could “get away with it.” But the IRS could audit their estates and reassess their gifts’ value, meaning those little white lies could haunt family members years after the taxpayer dies.

Now, a three-year “safe harbor” rule protects taxpayers. If you honestly disclose your gifts on Form 709, the IRS can’t audit your return once three years have elapsed. Even better, the IRS is barred from revisiting the issue in a subsequent audit of your estate. The stated value of the gifts is preserved for eternity!

Note: The safe-harbor rule doesn’t apply in case of fraud or inadequate disclosure. So, you can’t intentionally falsify the gift’s value and then claim safe-harbor rule should the IRS call.

Another twist: You’re also required to report transfers that you might not consider gifts, such as sales of business interests among family members. Those transfers are also protected by the three-year safe-harbor rule. That way, the IRS can’t later say you made an undisclosed gift if the sale reflects a discounted price.

The best way to value gifts of property or family business interests: Secure a professional appraisal.

Tip: You can write off the cost of an appraisal as a miscellaneous itemized deduction subject to the usual 2 percent-of-adjusted-gross-income limit.

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