Generally speaking, property transfers are included in the three-year rule if you transferred the property for less than fair market value. Gifts are exempt from the three-year rule if you did not have to file a gift tax return to claim the annual exclusion or did not have to pay the tax on the gift at the time you made it. However, this doesn’t include certain life insurance policies. For example, the three-year rule would still apply in the case of a policy gifted to an irrevocable life insurance trust.
What About the Estate Tax Exemption?
The federal gift tax goes hand in hand with the federal estate tax. They share a single lifetime exemption of $12.06 million for tax year 2022 and $12.92 million for tax year 2023. So long as the total combined amount of your estate and lifetime gifts does not exceed the lifetime exemption for the year in which you die, you do not have to file an estate tax return. The value of your lifetime gifts is the total of all gifts that:
Exceeded the small annual gift tax exclusion You didn’t pay the gift tax at the time you made them
For tax year 2022, the exclusion is up to $16,000 per person per year—the exclusion rises to $17,000 for tax year 2023. For example, for 2022, if the total of your lifetime gifts and your gross estate was $5 million, you would not owe the estate tax because that amount does not exceed $12.06 million. However, if the total came to $12.36 million, you’d owe taxes on $300,000—the difference after deducting the $12.06 million lifetime exemption. The taxable amount of your estate that exceeds the exemption amount is taxed at a rate of 40%.
Exceptions and Alternatives to the Three-Year Rule
You may be able to get around the three-year rule in the case of life insurance proceeds by reversing the order of the policy transfer. Rather than buying the policy, forming the irrevocable life insurance trust (ILIT), and then transferring the policy into the name of the trust, you could form the irrevocable trust first and then have it purchase the policy on your life. This way, the estate is the policy owner, not you, so it’s typically irrelevant to the value of your estate regardless of your date of death. The same exception applies if you’re the insured, but you never owned the policy on your own life because another person owns the policy. The three-year rule also doesn’t apply if you sell the policy to the ILIT. The keyword in this tax rule is “gratuitously.” You can’t give the policy away, but you can sell it—or any other asset—within three years of your death without adding its value to your estate. For example, you can’t sell something for $1 when it’s worth $1 million to escape the rule. You must sell the asset for its full fair market value.
