What Is the Three-Year-Rule?
The “three-year rule” is an estate tax provision of the U.S. Internal Revenue Code that applies in determining the assets included in a decedent’s gross estate. When individuals have made a transfer of assets, whether by trust or otherwise, within three years of their date of death, the value of the transferred assets may be included in their gross estates. If a decedent’s taxable estate exceeds the estate tax exemption, the value of such assets increases the estate's tax liability.
While gifts generally are excluded from estates, the three-year rule requires the inclusion of some gifts. Although gifts that do not exceed the annual gift tax exemption are exempt from the three-year rule and excluded from estates, the amount by which the fair market value of gifts exceeds the annual exclusion, plus the taxes paid on these gifts, is included.
- The “three-year rule” is a federal estate tax provision that includes in a decedent’s gross estate certain assets transferred for less than full fair market value consideration within three years of the individual’s death.
- Property sold for its full fair market value during the three-year period is not brought back into the owner’s estate.
- Gifts generally are exempt from the three-year rule.
- The rule does apply to gifts of the proceeds of life insurance on an owner’s life if the deceased owner retained any “incident of ownership”—a term that includes a reversionary interest worth more than 5% of the policy immediately prior to death.
Reasons for the Three-Year Rule
Congress enacted the three-year rule to discourage attempts to avoid estate taxes by transferring property when death is imminent. The rule originally covered a wide range of gifts and other transfers for less than fair market value. However, it was narrowed by subsequent legislation. At present the rule applies to transfers of property, including gifts of life insurance proceeds. with respect to which the decedent retained certain powers or ownership interests.
How the Three-Year Rule Works
The three-year rule applies to property transferred within three years of the date of death for less-than-full-fair-market-value consideration. Thus, the rule effectively brings back into a decedent’s estate for tax purposes both directly owned assets and beneficial interests in assets that would have been included in the decedent’s estate assuming that no transfer had occurred.
For 2022, the Internal Revenue Service (IRS) requires filing estate tax returns only for estates with taxable assets valued in excess of $12.06 million, including annual gifts exceeding the gift tax exclusion. For 2023, the threshold increases to $12.92 million, to account for inflation.
Transfers subject to the rule include revocable transfers, transfers with a retained life interest, transfers upon death, transfers of life insurance proceeds, and transfers where the decedent retains any powers or interests in the assets.
The tax law provides certain exceptions to the three-year rule. It does not apply to outright sales of assets for their full fair market value even if a sale occurred during the three-year period. Most gifts also are excluded from this claw-back rule; however, gifts exceeding the annual gift tax exclusion plus the taxes paid on them and certain gifts of the proceeds of life insurance on the owner-decedent’s life are subject to the rule.
Special Considerations: Estate Planning Uncertainty
Since the doubling of the estate tax exemption to $10 million per individual for years after 2017, the number of estates subject to taxation has decreased. Because of annual indexing for inflation, the exemption has risen in 2023 to free estates with a fair market value of up to $12.92 million from federal estate taxes. However, the law doubling and indexing the exemption expires at the end of 2025. Unless amended by legislation in the interim, the exemption decreases by approximately half for 2026.
What Is the Three-Year Rule?
The three-year rule is an Internal Revenue Code requirement that a decedent’s estate must include as estate assets certain property which the decedent transferred for less full fair market value within three years of the date of death.
Does the Three-Year Rule Apply to Gifts to Family Members Made Within Three Years of the Decedent’s Death?
The three-year rule generally does not apply to outright gifts made to anyone including family members. However, the rule does apply to gifts that were subject to the federal gift tax as well as the gift taxes paid on them. It also applies to gifts of the proceeds of life insurance on the decedent’s life, if the decedent retained any rights or powers of ownership, including a reversionary interest of greater than 5% of the policy value immediately prior to death.
Are All Estates Subject to Estate Taxation?
No, only estates whose value is higher than specific dollar thresholds, i.e., the estate tax exemption, are subject to estate taxation. The value of the taxable estate is determined by adjusting the gross estate for certain deductions. For the estates of individuals dying in 2022, the estate tax applies to taxable estates valued higher than $12.06 million. For 2023, the threshold rises to $12.92 million.
The Bottom Line
Although the Biden Administration proposed the enactment of an earlier expiration date for the increased exemption, Congress has taken no action. Assuming that the 2025 expiration date holds, transfers occurring as early as next year might be included in the estates of 2026 decedents pursuant to the three-year rule, and—with the far lower exemption level—might increase their exposure to taxes.
The looming, albeit uncertain, halving of the estate tax exemption in 2026 would affect estates above approximately $6 to $ 7 million in value, depending on inflation. Some estates valued lower than the exemption amount prescribed under present law for 2018-2025 would be subject to the estate tax.
The owners of these estates likely will examine estate-planning options, including gifts and other property transfers, to minimize potential liabilities while hoping, perhaps even lobbying, for legislation maintaining the higher exemption levels. In making their plans, they should be aware that the three-year rule may play a role in determining their estate tax liability.