What is the Three-Year-Rule?

The three-year rule refers to Section 2035 of the U.S. tax code. It stipulates that assets that have been gifted through an ownership transfer, or assets for which the original owner has relinquished power, are to be included in the gross value of the original owner's estate. But only if the transfer took place within three years of his or her death. If gifted assets do not meet the requirements, the value of the assets is added to the value of the estate at the time of the original owner's death, increasing its value and the estate taxes imposed on it.

Key Takeaways

  • The three-year rule is a reference to a particular section (Section 2035) of the U.S. tax code having to do with gifted assets.
  • The rule pertains (mainly) to assets or insurance policies.
  • One of many gifting strategies includes living trusts gifting that occurs when a person is still alive, unlike a will.

How the Three-Year Rule Works

The three-year rule prevents individuals from gifting assets to their descendants or other parties once death is imminent in an attempt to avoid estate taxes. The rule does not include all assets gifted or transferred in those three years and is mainly focused on insurance policies or assets in which the deceased retains an interest.

The estate tax can be high; therefore, many families planning their states work out deliberate estate planning strategies, balancing the chance to leave significant assets to their beneficiaries or heirs, and the cost of the tax. The estate tax covers everything one owns or has interests in at the date of death, including but not limited to cash and securities, real estate, insurance, trusts, annuities, and business interests.

The fair market value of these assets are used, which is different (and often higher) than the amount the individual originally acquired them for. The total of all of these items is termed the gross estate.

After filing the gross estate, certain deductions are allowed in arriving at one’s taxable estate, including mortgages, other debts, administration expenses, qualified charities, and property that passes to surviving spouses. This leads to the estate’s net amount, and the tax is computed.

As of 2020, the Internal Revenue Service (IRS) only requires a filing for estates with combined gross assets and prior taxable gifts exceeding $11,580,000. For 2021, that increases to $11.70 million.

Special Considerations

Several gifting strategies exist to help bring down the estate value and avoid the highest levels of taxation. These include but are not limited to living trusts gifting, which takes place when one is still alive.

When gifting, it’s important to distribute property that will appreciate substantially in the future, especially if it hasn't increased in value already. This will exclude its present worth from the donor's estate and also eliminate future appreciation from the estate.