Revenue Ruling 79-32: Income Tax Rules for Net Gifts

Revenue Ruling 79-32 provides income tax guidance for a “net gift,” a specific type of property transfer where the recipient (the donee) agrees to pay the gift tax that the person giving the gift (the donor) would otherwise owe. This arrangement creates tax consequences for both parties involved. The Internal Revenue Service (IRS) does not view this as a simple gift but as a more complex transaction with distinct income tax implications for the donor.

The Core Principle of the Ruling

The central idea of Revenue Ruling 79-32 is that a net gift is a hybrid transaction that is part gift and part sale. The “sale” component arises because the donor, who is legally obligated to pay the federal gift tax, is relieved of this debt by the donee. From the IRS’s perspective, being relieved of a financial liability constitutes an economic benefit, treated as an “amount realized” by the donor.

This interpretation was affirmed by the Supreme Court in the case Diedrich v. Commissioner. The Court reasoned that when a donee pays the donor’s gift tax obligation, the donor receives an economic benefit, and this discharge of debt is considered income. The Diedrich decision solidified the principle that a net gift transaction can trigger an income tax liability for the donor if the gift tax paid by the donee is greater than the donor’s investment in the property.

Calculating the Donor’s Taxable Income

To determine if a net gift creates taxable income for the donor, two pieces of information are necessary: the donor’s adjusted basis in the gifted property and the total gift tax the donee pays. The donor’s adjusted basis is the original purchase price of the asset, plus the cost of any capital improvements, minus any depreciation taken. The gift tax liability is the amount calculated based on the value of the gift, which the donee contractually agrees to pay.

The formula for calculating the donor’s taxable income is: Taxable Income = Gift Tax Paid by Donee – Donor’s Adjusted Basis. Income is recognized only if the gift tax paid by the donee exceeds the donor’s adjusted basis. If the gift tax is less than or equal to the donor’s basis, the donor does not recognize any taxable income from the transaction.

For example, consider a donor who gifts stock with an adjusted basis of $50,000. The stock’s value triggers a federal gift tax of $120,000, which the donee agrees to pay. The donor’s taxable gain is calculated as $120,000 (Gift Tax Paid) – $50,000 (Donor’s Adjusted Basis), which equals $70,000. The donor must report this $70,000 as a capital gain, and its character as short-term or long-term depends on the donor’s holding period.

Determining the Donee’s Basis

The net gift transaction also has consequences for the donee’s tax basis in the acquired property, which is used to calculate their capital gain or loss upon a future sale. Because a net gift is treated as a part-sale and part-gift, the basis calculation is unique. The donee’s basis is the greater of either the donor’s adjusted basis or the gift tax paid by the donee.

This amount is increased by any gift tax paid that is attributable to the net appreciation of the property, which is the amount the property’s fair market value exceeds the donor’s basis. This adjusted basis is a benefit for the donee, as it can reduce their future capital gains tax liability.

Tax Reporting and Filing Requirements

Both the donor and the donee have specific responsibilities following a net gift transaction, though the donor’s are more immediate. The donor must complete two separate tax filings to properly report the transaction to the IRS.

First, the donor must file Form 709, United States Gift Tax Return. On this form, the donor reports the full fair market value of the gift. The gift tax liability that the donee paid is then subtracted to calculate the net taxable gift. This form must be filed even though the donee is paying the tax.

The second filing requirement is reporting the income on Form 1040, Schedule D, Capital Gains and Losses. This is where the “sale” portion of the net gift is documented for income tax purposes. The gain is treated as if the donor sold the asset for an amount equal to the gift tax paid by the donee.

The donee has no immediate tax filing requirement for receiving the gift. Their primary responsibility is to maintain accurate records of their new basis in the property. This documentation will be necessary for accurately calculating and reporting their capital gain or loss when they sell the property in the future.