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Estates and Taxes 101

When a loved one passes, things can be difficult enough. Throw complicated tax issues into the mix and you have the recipe for a full blown nightmare.

Clients will often ask for an overview of the potential tax issues associated with the passing of a loved one. This article presents a general overview of some of those issues.

A. Estate Tax

The Estate Tax is one of those issues that you may have heard being addressed by politicians in recent years. It has also been referred to as the “Death Tax.”

Essentially the idea is that once a loved one passes, the government will tax a portion of his or her estate before the estate can be transferred to heirs. This is the “estate tax” which is not to be confused with “estate income tax” which we will talk about later.

Another important component of the estate tax is that it has what is called an “exemption amount.” This is the amount of the estate that is not subject to tax. As a result, only that portion of the estate that is in excess of the exemption amount gets taxed.

Let’s see how this plays out. So in 1997, the exemption amount was $600,000. Let’s say Aunt Sally passed away with an estate worth $1,000,000. Aunt Sally would not have to pay tax on the first $600,000 of the estate. As a result, Aunt Sally only pays estate tax on the $400,000 of her estate that is over the exemption amount.

The good news for most people is that, over the years, this exemption amount has risen quite dramatically. In 2010, the exemption amount was raised to $5,000,000. In 2019, it was raised again to $11,000,000.

So these days, unless you have an estate that approaches these amounts, you do not have to worry about estate tax.

B. Income Taxes for the Decedent and the Estate

Once a loved one passes, it will be the executor’s responsibility to file the final income tax for that person. This essentially the same as the income tax filings that the person filed while living – only now the executor must file the return since the taxpayer is no longer around to do it for him or herself.

Additionally, keep in mind that the estate itself may need to file its own income tax returns. Remember that the probate process can last up to a year or more. During this time the estate, itself, may generate income. For example, consider an estate that consists of rental properties. If these properties are generating income, that income is no longer the income of the person that passed away – it is income of the estate itself. So the estate (through the executor) will have to file an income tax return for the estate.

C. Capital Gains on Inherited Assets

This is another tax issue that can come up when loved ones pass. First, let’s talk about capital gains.

A capital gain occurs when we buy an asset, then sell it later for a higher price. So consider a house. If we buy a house for $500,000 then sell it two years later for $750,000, that is a capital gain of $250,000. Once the sale occurs and we have “realized” the gain, the government gets to tax that gain.

Let’s examine this little hypothetical a bit further. In order to calculate the “gain” in this example, we had to look at the purchase price. Once we sold the asset, we subtracted the purchase price from the sale price in order to calculate the gain.

This is exactly how we would calculate the gain for tax purposes. Except that in the tax world, the purchase price would be referred to as our “basis.”

In the regular tax world, we calculate capital gains as we have described above. However, when an asset is inherited – we apply a special rule in order to calculate the capital gain. This is the “step up in basis” rule.

Let’s revisit our hypothetical again, but with some changes. Pretend that Aunt Sally bought her house in 2014 for $500,000. Aunt Sally then passes away in 2022 (her house is now worth $750,000) and leaves her house to her son, Joe.

If Joe were to sell the house in 2022, we would calculate that he has a capital gain of $250,000. But because the house is an inherited asset, a special rule applies.

Before we describe what a “step up” in basis is, we should first define what a “basis” is. In this example, the “basis” would be the purchase price of the property: $500,000. That number is the ‘basis’ for calculating the capital gain.

So how do we step this up? Well, if the asset is inherited, we are allowed to use a different number as our “basis.” For an inherited asset, we use the fair market value on the date of death of the previous owner.

In our example, this is very beneficial for Joe. This is because, since the house has been appreciating in value, the fair market value in 2022 would be much more than the purchase price. Since the fair market value in this example is closer to the sales price, the difference between the two (i.e. the capital gain) would be smaller. Since the capital gain is smaller, the tax on the capital gain is smaller also.


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