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A loved one passes away, what happens tax-wise? Good question, especially if you’re the one responsible for dealing with tax matters and especially if major bucks are in play. This column addresses some of the most important tax-related considerations. You can read Part 1 here.
Claim basis step-up for inherited assets, while it lasts
If your deceased loved on (the decedent) left appreciated capital gain assets — such as real property and/or securities held in taxable brokerage firm accounts, the federal income tax basis of those assets are increased to reflect fair market value (FMV) as of: (1) the decedent’s date of death or (2) the alternate valuation date of six months later if the executor of the estate chooses to use the alternate valuation date.
Then, when an inherited capital gain asset is sold, federal capital gains tax is only owed the appreciation (if any) that occurs after the applicable magic date. This pro-taxpayer rule can dramatically lower or even eliminate the federal income tax hit when an inherited asset is sold.
• If the decedent was married and co-owned one or more homes and/or other capital-gain assets with the surviving spouse, the tax basis of the fraction that was owned by the decedent (usually half) is stepped up to FMV as of the applicable magic date.
• If the decedent was married and co-owned one or more homes and/or other capital gain assets with the surviving spouse as community property in one of the nine community property states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin), the tax basis of the entire asset is stepped up to FMV — not just the half that was owned by the decedent. This strange-but-true rule means the surviving spouse can sell capital gain assets that were co-owned as community property and only owe federal capital gains tax on the appreciation (if any) that occurs after the applicable magic date. So little or nothing may be owed.
Warning no. 1: Under the proposed Biden tax plan, most appreciated property received as an inheritance would be treated as if it was sold for FMV on the date of the owner’s death, subject to a $1 million per-person exemption. This proposed change would affect property inherited from individuals who die after Dec. 31, 2021. However, the proposed change would not affect property inherited by a surviving spouse, but the surviving spouse would take over the deceased spouse’s lower tax basis in the property rather than receiving a stepped-up basis allowed under current law. A surviving spouse could also take advantage of the gain exclusion explained below for profit from selling a principal residence.
Warning no. 2: More potential bad news for heirs who inherit appreciated assets: the proposed Biden tax plan would also retroactively increase the maximum federal rate on net long-term capital gains, after any allowable basis step-up, to 39.6% for gains recognized after some magic date this year. After tacking on the 3.8% net investment income tax (NIIT), the proposed maximum effective rate would be 43.4% (39.6% + 3.8%) compared to the current maximum effective rate of “only” 31.8% (28% + 3.8%). However, the proposed rate increase would only apply to taxpayers with adjusted gross income (AGI) above $1 million, or above $500,000 if you use married filing separate status.
Take advantage of bigger home-sale gain exclusion for surviving spouse, but mind the deadline
An eligible unmarried individual can exclude from federal income taxation up to $250,000 of gain from selling a principal residence. Married joint-filing couples can exclude up to $500,000.
If your deceased loved one was married, the surviving spouse is generally not allowed to file a joint return for tax years after the year during which the decedent died — unless the surviving spouse is a qualified widow/widower or he or she remarries. Nevertheless, an unmarried surviving spouse can usually claim the larger $500,000 joint-filer gain exclusion for a principal residence sale that occurs within two years after the decedent’s date of death.
This is a taxpayer-friendly rule, but pay attention to the deadline. Since the two-year period begins on the date of the decedent’s death, a sale that occurs in the second calendar year following the year of death but more than 24 months after the date of death will not qualify for the larger $500,000 gain exclusion.
On the other hand, if the surviving spouse sells any time during the calendar year after the year that includes the deceased spouse’s date of death (2022 if death occurs in 2021), the sale will automatically be within the two-year window, and the larger $500,000 gain exclusion will be available to the surviving spouse.
Beware of required minimum distribution rules for inherited retirement accounts
The dreaded required minimum distribution (RMD) rules generally apply to inherited IRAs and inherited qualified retirement plan account balances. Beneficiaries who inherit balances in these accounts cannot afford to ignore the RMD rules. Failure to withdraw the properly calculated RMD amount for any year exposes the beneficiary to a 50% penalty based on the shortfall between the required amount for the year and the amount actually withdrawn during the year, if anything. The 50% penalty is one the harshest punishments in the Internal Revenue Code, and the penalty can stack up year-after-year until compliance with the RMD rules is achieved.
Surviving spouse is beneficiary
If the surviving spouse is the sole beneficiary of the decedent’s IRA or qualified retirement plan account, special RMD rules apply. And an RMD may have to be taken as early as Dec. 31 of the year that includes the decedent’s date of death.
The surviving spouse can usually achieve better tax results under the RMD rules if he or she can choose and does choose to treat the inherited account as his or her own account. Then RMDs can be calculated under the more-favorable rules that apply to original account owners, and the surviving spouse won’t have to take any RMDs until after turning age 72.
Tax planning point: Say the surviving spouse is under age 59½ and needs to withdraw some money from an inherited account. Withdrawals while the account is still in the deceased spouse’s name are exempt from the dreaded 10% early withdrawal penalty tax. However, withdrawals from an account that has been retitled in the surviving spouse’s name will generally get hit with the 10% penalty tax unless the surviving spouse is age 59-1/2 or older. So, the surviving spouse should withdraw the needed money from the inherited account before retitling it in his or her own name.
Other beneficiary scenarios
When one or more non-spouse beneficiaries inherit a traditional IRA, Roth IRA, or qualified retirement plan account balance, special RMD rules apply. Special rules also apply to accounts with multiple designated beneficiaries. You will be unsurprised to hear that these special rules can be complicated. And an RMD may have to be taken as early as Dec. 31 of the year that includes the decedent’s date of death. Consult a tax professional for details.
The bottom line
When a loved one passes away, the tax considerations explained in this column can affect heirs. And there’s much more to the story, so please stay tuned for future columns on the subject. Finally, know this: when a loved one dies and major bucks are in play, seeking advice from a good tax pro with experience in estate tax matters is probably worth the cost. Keep in mind that there may be state income tax issues to consider too.
