Since 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 $12,000 per donee in 2007 and 2008 and up to $13,000 per donee in 2009 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 2007 and 2008, Eva and Henry made tax-free gifts totaling $96,000 to their children ($24,000 per child), and in 2009 they will make tax-free gifts totaling $102,000 ($26,000 per child). Continuing this pattern through the years, Eva and Henry will reduce substantially their taxable estate as they provide generously for their children.

If you give away more than $12,000 to any one person in a year (or more than $24,000 if your spouse consents to the gift), the gift counts against your unified credit amount, which is $2 million for 2006 through 2008. Thus, if you give away $112,000 to your child, your estate tax exclusion has just dropped by $100,000.

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. Ignoring the annual exclusion for this example, assume that an individual transfers property that is now worth $24,000. When the donor dies 10 years later, the property is worth $200,000. Although the $24,000 is included in the computation of property subject to the unified transfer tax, the $176,000 escapes taxation.

Did You Know? If he is really worth an estimated $26.35 billion (based on Microsoft's current stock price), and his wife agreed to split gifts, Bill Gates could make gifts of $24,000 to 1,084,791 people in 2007, and still not have to pay any gift tax!