A net gift arrangement is a transfer in which the recipient agrees, as a condition of accepting the property, to pay the federal gift tax that would normally fall on the donor. Shifting that payment shrinks the taxable value of the transfer, because the recipient’s tax payment counts as consideration flowing back to the donor. For someone who has used up the $15 million lifetime exclusion and holds wealth in illiquid assets like real estate or a closely held business, this can make a large lifetime transfer possible without selling the asset to raise cash for taxes.1Internal Revenue Service. What’s New — Estate and Gift Tax
How It Differs From an Ordinary Gift
In a standard gift, the donor transfers property and is solely responsible for any gift tax. The top federal gift tax rate is 40%, and the donor either pays from separate funds or uses lifetime exclusion to offset the liability.1Internal Revenue Service. What’s New — Estate and Gift Tax IRC Section 2502(c) states plainly that the gift tax “shall be paid by the donor,” and no statutory exception exists for net gifts.2Office of the Law Revision Counsel. 26 USC 2502 – Rate of Tax
What the IRS and the courts have long accepted is that the donor and recipient can privately reallocate the economic burden of that tax. When the recipient takes on the payment obligation, they are giving something of value back to the donor, namely relief from a legal debt. That makes the transaction part gift and part sale. Every consequence discussed below flows from that dual character.
What Has to Be True for a Net Gift to Work
Three conditions matter.
First, the donor must have exhausted the lifetime exclusion. A net gift only shifts something if there is tax actually owed. Under the One, Big, Beautiful Bill signed in July 2025, the lifetime exclusion is $15 million per person, indexed for inflation. The annual per-recipient exclusion is $19,000 in 2026.1Internal Revenue Service. What’s New — Estate and Gift Tax If the donor still has exclusion available to absorb the transfer, no tax is due and there is nothing to shift.
Second, there needs to be a binding written agreement in place at the time of the transfer, signed by donor and recipient, stating that the recipient will pay the gift tax. Oral understandings are technically possible but hard to defend on audit.
Third, the agreement should identify the property, its fair market value, the donor’s adjusted basis, and the formula for computing the recipient’s tax obligation. Documenting the arrangement this way heads off any IRS attempt to recharacterize the recipient’s tax payment as a separate taxable gift running back the other way.
How the Tax Is Calculated
The recipient’s promise to pay the tax reduces the value of the gift, but the tax depends on that reduced value. The problem is circular: you cannot compute the tax without knowing the gift value, and you cannot fix the gift value without knowing the tax. Revenue Ruling 75-72 supplies the resolving formula:
Gift tax = Tentative tax ÷ (1 + tax rate)
Anyone using a net gift has already passed the $15 million exclusion, so the marginal rate on the taxable portion is 40% in every realistic case. The graduated schedule technically starts at 18%, but the 40% bracket takes over above $1 million of cumulative taxable gifts, a threshold the exclusion dwarfs.1Internal Revenue Service. What’s New — Estate and Gift Tax
A Worked Example
Say you want to give your daughter property worth $1 million and your lifetime exclusion is gone. As an outright gift, the tax at 40% is $400,000, and you owe it. In a net gift, your daughter agrees to pay. Running the formula: $400,000 ÷ 1.40 = $285,714. She pays $285,714 to the IRS and keeps property worth $714,286. Check the math: 40% of $714,286 is $285,714.
The practical result is that instead of the donor needing $400,000 of separate cash on top of parting with the property, the recipient pays about $285,700, and the total transfer tax is lower because the taxable base is smaller. For donors whose wealth sits inside a single hard-to-sell asset, this is often the difference between making the transfer and not making it.
The Donor’s Income Tax Surprise
The Supreme Court’s 1982 decision in Diedrich v. Commissioner establishes a rule that catches many donors off guard: when the recipient’s gift tax payment exceeds the donor’s adjusted basis in the property, the donor recognizes taxable income equal to the difference.3Supreme Court of the United States. Diedrich v. Commissioner, 457 U.S. 191 (1982) The reasoning is that the recipient’s payment relieved the donor of a legal obligation, and debt relief is treated like receiving cash.
Back to the example. If the donor’s basis in the property was $100,000 and the recipient paid $285,714, the donor recognizes $185,714 of capital gain, reported on Schedule D of Form 1040.4Internal Revenue Service. About Schedule D (Form 1040), Capital Gains and Losses For 2026, long-term capital gains rates are 0% for single filers with taxable income up to $49,450, 15% up to $545,500, and 20% above that.5Internal Revenue Service. Topic No. 409, Capital Gains and Losses Most donors making a net gift of this size will land in the 15% or 20% bracket.
This is why the strategy fits poorly with highly appreciated, very low-basis assets. Stock bought for $10,000 that is now worth $2 million produces a large capital gain when the net gift is made, and the combined gift tax and income tax cost may exceed what an outright gift would have cost. Run the numbers before committing.
The Recipient’s Basis Gets an Adjustment
Recipients ordinarily carry over the donor’s basis. In a net gift, the recipient gets a partial basis increase reflecting the gift tax paid. Under IRC Section 1015(d)(6), the increase equals the portion of the gift tax attributable to the property’s net appreciation (fair market value minus donor’s basis).6Office of the Law Revision Counsel. 26 U.S. Code 1015 – Basis of Property Acquired by Gifts and Transfers in Trust
Multiply the gift tax paid by a fraction whose numerator is the net appreciation and whose denominator is the gift amount. Using the example numbers, net appreciation is $900,000 ($1,000,000 minus $100,000), the gift for this purpose is $714,286, and the computed adjustment is $285,714 × ($900,000 ÷ $714,286), or about $360,000. The increase, though, cannot exceed the tax paid, so it caps at $285,714. The recipient’s basis becomes $385,714 ($100,000 carryover plus $285,714).
The higher basis matters when the recipient later sells: less capital gain, less income tax on the sale. Any honest evaluation of a net gift has to account for that step-up.
The Three-Year Estate Tax Trap
Timing matters. IRC Section 2035(b) pulls any gift tax paid within three years of the donor’s death back into the donor’s gross estate.7Office of the Law Revision Counsel. 26 USC 2035 – Adjustments for Certain Gifts Made Within 3 Years of Decedent’s Death The statute reaches “any tax paid under chapter 12 by the decedent or his estate,” and in a net gift the recipient is paying that tax on the donor’s behalf. Courts have generally treated these payments as falling within Section 2035(b)’s scope.
If the donor dies within three years of making a net gift, the tax the recipient paid can be added back to the taxable estate and generate additional estate tax at 40%. That erases much of the benefit. Donors in poor health or of advanced age should weigh this risk before proceeding, and it is one reason advisors often suggest making large gifts sooner rather than later.
Reporting and Paying
The donor files IRS Form 709 to report the transaction.8Internal Revenue Service. About Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return The return is due April 15 of the year following the gift.9Internal Revenue Service. Filing Estate and Gift Tax Returns On Schedule A, the donor reports the full fair market value of the property and then reduces it by the amount of tax the recipient has agreed to pay, with a clear explanation of the net gift arrangement and the interrelated computation.
Keep the following with the return or in the donor’s files:
- The signed net gift agreement.
- A qualified appraisal establishing fair market value on the date of the gift, particularly important for real estate, business interests, and other assets without an obvious market price.
- Records supporting the donor’s adjusted basis, needed both for the interrelated calculation and for the Diedrich gain.
- Worksheets showing the step-by-step interrelated computation.
Automatic six-month filing extensions are available, either by filing Form 4868 (the individual income tax extension, which also extends Form 709) or Form 8892 for the gift tax return specifically.10Internal Revenue Service. Instructions for Form 8892 The extension covers filing, not payment. Tax is still due April 15, and interest accrues on any unpaid balance from that date. Late-filing penalties run 5% of unpaid tax per month, up to 25%.11Internal Revenue Service. Failure to File Penalty The recipient, who owes the tax under the agreement, can pay through the Electronic Federal Tax Payment System or by mailing a check with a payment voucher.
When It Fits and When It Doesn’t
Net gifts work best when the donor has fully used the lifetime exclusion and holds valuable but illiquid assets, and the recipient has the cash to cover the tax. A donor with $20 million in commercial real estate and limited liquid savings can transfer a building to a child who can write the check to the IRS. The property does not have to be sold, and the total transfer tax comes out lower than on an outright gift because the taxable base is smaller.
The strategy works poorly in three situations. When the donor’s basis is very low relative to current value, the Diedrich income tax can wipe out the savings. When the donor is elderly or in poor health, the three-year rule under Section 2035(b) can pull the tax back into the estate. And when the donor still has lifetime exclusion available, there is no tax to shift, so the arrangement adds nothing.
Net gifts to irrevocable trusts are common in estate planning, with the trust rather than an individual beneficiary taking on the tax obligation. The mechanics are the same, but the trust document must explicitly authorize the trustee to pay the gift tax. That version calls for both a tax advisor and an estate planning attorney, so the trust language and the net gift agreement line up.