Since, after 2010 and before 2013, lifetime gifts and transfers at death are added together for purposes of the unified transfer tax, and taxed at the same rate, how can it be that lifetime gifts can save you transfer taxes? Two reasons: first, the gift tax annual exclusion, and second, the fact that any appreciation in property value that occurs after the transfer is not taxable to the decedent's estate.

Gift tax annual exclusion. A special provision, called the gift tax annual exclusion, generally allows you to transfer, each year, up to $13,000 per donee in 2011 without incurring any gift tax liability. None of the gifts you make subject to the annual exclusion are included in your taxable estate for purposes of the estate tax.

Another wrinkle to the gift tax annual exclusion is that spouses are allowed to treat gifts made by one spouse as if they are made by both of them (this is called a "split gift"), even when only one of them actually owned and contributed the property.

Taken together, these provisions allow people with available assets to give away substantial amounts over time.

Eva, who owns a computer software company in her home state of Illinois, is extremely wealthy. Her husband, Henry, who is a school teacher, is not. For the past several years, Eva and Henry have used the gift tax annual exclusion to give the maximum tax-free gifts to each of their four children. Eva contributes the entire amount used for the gifts, but because she and Henry make the "split gift" election, Henry is credited with making half the gift. Therefore, they are able to double the annual exclusion for which she would be eligible individually. As a result, in each of 2008 and 2009, Eva and Henry made tax-free gifts totaling $96,000 to their children ($24,000 per child). In 2010, they made tax-free gifts totaling $102,000 ($26,000 per child), and will do the same again in 2011. Continuing this pattern through the years, Eva and Henry will reduce substantially their taxable estate as they provide generously for their children.

Because of the unified system for taxing gifts and estates, if you give away more than the gift tax annual exclusion amount of $13,000 to any one person in a year, the gift counts against your applicable exclusion amount for estate tax, which is 5 million for 2010 through 2012. Thus, if you gave property worth $113,000 to your niece in 2009, you used up $100,000 of your applicable exclusion amount for your estate.

This is not necessarily bad. Because any appreciation in the property's value after the date of the gift escapes transfer taxation, you can save future taxes by giving away property that is likely to increase in value. Assume that you gave the property worth $113,000 to your niece in 2009. Let's say you die in 2024, when the property is worth $500,000. Although the $100,000 is applied against the applicable exclusion amount because of the unified system, the $387,000 in appreciated value of the property escapes taxation.