Tax Considerations When a Loved One Passes Away (Part 1 of 3)

Parts of this article are published with permission from Bradford Tax Institute, © 2021 Daniel Morris, Morris + D’Angelo

During these challenging times dealing with COVID-19 and the additional challenges economic and otherwise it brings, if a loved one passes away and you serve as the executor or inherit assets, you need to consider your duties and so some tax planning.

The now-deceased loved one may have been single or married, and may or may not have been a relative. In any case, you’ve stepped up to the plate and taken on the challenging job of acting as executor for the deceased person’s estate. Good for you.

But it can be a lot of work, and handling tax matters is an important part of it. This article is the first of our three-part series on what you, as the executor, need to know about the most important federal tax issues. So please read this, and then stay tuned for Parts 2 and 3.

Key Point: There may be state tax issues too, but those are beyond the scope of our analysis.

The Executor’s Role

When a loved one passes away, someone must handle the resulting financial fallout, including the tax issues. That person may be identified in the “decedent’s” (the deceased loved one’s) will as the executor of the decedent’s estate.

If there is no will, the probate court will appoint an administrator.

In either case, it will often be the surviving spouse or another family member who takes on the responsibility. In this article, we will refer to that person as the “Executor.” That would be you.

Your role as the executor is to identify the estate’s assets, pay off its debts, and distribute the remainder to the rightful heirs and beneficiaries. You are also responsible for filing any necessary tax returns and arranging to pay any taxes.

Filing the Final Form 1040 for Unmarried Decedent

If the decedent was unmarried, an initial step is to file his or her final Form 1040.

That return covers the period from January 1 through the date of death. The return is due on the standard date: for example, April 15, 2021, for someone who dies in 2020, or October 15, 2021, if you extend the return to that date.

Advice: With all your executor duties, you’ll probably become pressed for time. If so, extend the return.

Surviving Spouse Can File Joint Form 1040 for Year of Death

Say a married loved one died this year. Unless the surviving spouse remarries by December 31, 2020, he or she is considered unmarried for all of 2020 for federal income tax purposes.

Nevertheless, the surviving spouse can still file a final joint Form 1040 with the deceased spouse for 2020 and thereby benefit from the more taxpayer-friendly rates and rules that apply to joint-filers.1 The final joint return will include the deceased spouse’s income, deductions, and credits plus the surviving spouse’s income, deductions, and credits for the entire year.

Key Point: If the surviving spouse remarries on or before December 31, 2020, married-filing-separate status must be used for the deceased spouse’s final Form 1040 for the 2020 tax year.

Surviving Spouse May Be Able to Use Joint Return Rates for Two Years Following Deceased Spouse’s Year of Death

The benefits of the married-filing-joint status are extended to a qualified widow or widower for the two tax years following the year of the deceased spouse’s death.

In general, to be a qualified widow/widower for the year, the surviving spouse must be unmarried as of the end of the year.

The surviving spouse must also pay more than half the cost of maintaining a home that is the principal home for the entire year of a child of the surviving spouse (including a stepchild) who qualifies as a dependent of the surviving spouse.

Finally, the surviving spouse must have been eligible to file a joint return with the now-deceased spouse for the tax year of the deceased spouse’s death.

If Decedent Had a Revocable Trust

To avoid probate, many individuals and married couples of means set up revocable trusts to hold valuable assets, including real property and bank and investment accounts.

These revocable trusts are often called “living trusts” or “family trusts.” For federal income tax purposes, they are properly described as “grantor trusts.”

As long as the trust remains in revocable status, it is a grantor trust, and its existence is disregarded for federal income tax purposes. Therefore, the grantor or grantors are treated as still personally owning the trust’s assets for federal income tax purposes, and tax returns of the grantor(s) are prepared accordingly.

Unmarried Individual

When an unmarried individual passes away, his or her grantor trust becomes irrevocable.

As such, the trust is now treated as a separate taxpayer that is subject to the federal income tax rules for trusts. This is not a favorable development, because the 2020 tax rates on undistributed trust income quickly climb to the maximum 37 percent rate for ordinary income and net short-term capital gains and the maximum 20 percent rate for net long-term capital gains and qualified dividends. (See the rate table below.)

If the 3.8 percent net investment income tax (NIIT) also applies, the 2020 marginal federal income tax rate on a trust’s undistributed investment income and gains can be as high as 40.8 percent/23.8 percent. Ouch!

Married Couple

For married couples, revocable trusts typically continue to exist as such when the first spouse passes away. In that case, the trust continues to be a grantor trust, and its existence continues to be disregarded for federal income tax purposes. The surviving spouse’s Forms 1040 are prepared without regard to the trust.

But when the surviving spouse passes away, the trust becomes an irrevocable trust that’s subject to the potentially negative federal income tax consequences mentioned above.

2020 Federal Income Tax Rates and Brackets for Trusts

The rate brackets for 2020 are as follows:

Rate Brackets for Trust Ordinary Income and Net Short-Term Capital Gains

10% tax bracket: $ 0-2,600

Beginning of 24% bracket: $2,601

Beginning of 35% bracket: $9,451

Beginning of 37% bracket: $12,951

Rate Brackets for Trust Net Long-Term Capital Gains and Qualified Dividends

0% tax bracket: $ 0-2,650

Beginning of 15% bracket: $2,651

Beginning of 20% bracket: $13,151

Tax Planning Advice: If you are going to avoid these unfriendly federal income tax rates, it is important to get income and gains out of the trust by distributing them to the trust beneficiaries. It may be advisable to wind up the trust to avoid continued exposure to unfavorable trust tax rates.

Basis Step-Ups for Inherited Assets

If the decedent left appreciated capital gain assets—such as real property and securities held in taxable accounts, the heir(s) can increase the federal income tax basis of those assets to reflect fair market value as of:

1. The decedent’s date of death, or
2. The alternate valuation date of six months after the date of death, if the executor of the decedent’s estate chooses to use the alternate valuation date.

When the inherited asset is sold, the federal capital gains tax applies only to the appreciation (if any) that occurs after the applicable magic date described above. The step-up to fair market value can dramatically lower the tax bill. Good!

Co-ownership: 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 ownership interest(s) that belonged to the decedent (usually half) is stepped up.

Community property: 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—not just the half that belonged to the decedent—is stepped up to fair market value.

This strange-but-true rule means the surviving spouse can sell capital gain assets that were co-owned as community property and owe federal capital gains tax only on the appreciation (if any) that occurs after the applicable magic date.6 That means little or no tax may be owed. Good!

Bigger Joint-Filer Home Sale Gain Exclusion Is Available to Surviving Spouse, but Only for a While

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 of gain.

If the decedent was married, the surviving spouse is generally not allowed to file a joint return for tax years after the year during which the deceased spouse died—unless the surviving spouse is a qualified widow/widower (explained earlier) or he or she remarries.

Nevertheless, an unmarried surviving spouse can take advantage of the larger $500,000 joint-filer gain exclusion for a principal residence sale that occurs within two years after the deceased spouse’s date of death.

This is a beneficial rule but mind the deadline. Since the two-year period begins on the date of the deceased spouse’s death, a sale that occurs in the second calendar year following the year of death but more than 24months after the date of death will not qualify for the larger $500,000 gain exclusion.

On the other hand, if the surviving spouse sells at any time during the calendar year after the year that includes the deceased spouse’s date of death (that would be 2021 if the deceased spouse died in 2020), the sale date will automatically be within the two-year window, and the larger $500,000 gain exclusion will be available.

Required Minimum Distribution (RMD) Rules for Inherited Retirement Account Balances

The dreaded required minimum distribution (RMD) rules generally apply to inherited individual retirement accounts (IRAs) and qualified plan balances. Beneficiaries cannot afford to ignore the RMD rules.

Failure to withdraw the properly calculated RMD amount for any year exposes beneficiaries to a 50 percent penalty based on the shortfall between the required amount for the year and the amount actually withdrawn during the year if any. The 50 percent penalty is one of the harshest punishments in the Internal Revenue Code, and it can stack up year after year until properly calculated RMD amounts are withdrawn.

Non-Spouse Is Beneficiary

If one or more non-spouse beneficiaries inherit a traditional IRA, Roth IRA, or qualified plan account balance, special RMD rules apply. Those rules can be complicated and are beyond the scope of our coverage here. An RMD may have to be taken by December 31 of the year of death, with the resulting extra income tax hit. Thankfully, the RMD rules are suspended for 2020, as explained below.

Surviving Spouse Is Beneficiary

If the decedent’s surviving spouse inherits as the sole beneficiary the decedent’s IRA or qualified retirement plan account, RMD rules apply here too. An RMD may have to be taken by December 31 of the year of death, with the resulting extra income tax hit. But as mentioned, thankfully, the RMD rules are suspended for 2020, as explained below.

The surviving spouse will usually achieve better tax-deferral results under the RMD rules if he or she can choose to treat the inherited account as his or her own account. Then RMDs can be calculated under the generally more-favorable rules that apply to an original account owner.

Tax planning advice: Say the surviving spouse is under age 59 1/2 and needs to withdraw some money from the inherited account. Withdrawals, while the account is still in the decedent’s name, are exempt from the dreaded 10percent early withdrawal penalty tax.

But withdrawals from an account that has been put into the surviving spouse’s name are generally hit with the 10percent penalty tax unless the surviving spouse is age 59 1/2 or older or a tax-law exception applies.

Multiple Individual Beneficiaries, or Trust, or the Decedent’s Estate Is Beneficiary

In these scenarios, the RMD rules can be tricky. You are probably well-advised to get a tax pro involved if the decedent had substantial retirement account balances.

RMD Rules Are Suspended for 2020

Thankfully, the Coronavirus Aid, Relief, and Economic Security (CARES) Act suspended the RMD rules for RMDs that would otherwise have to be taken in the calendar year 2020. Good!

For 2021 and beyond, the RMD rules will be applied basically as if 2020 never happened. In other words, all the RMD deadlines are pushed back by one year, and any deadlines that would have otherwise applied for 2020 are simply ignored.

Takeaways

If you are the executor, your duty is to identify the estate’s assets, pay off its debts, and distribute the remainder to the rightful heirs and beneficiaries. You are also responsible for filing any necessary tax returns and arranging to pay any taxes.

The benefits of the married-filing-joint status are extended to a qualified widow or widower for the two tax years following the year of the deceased spouse’s death.

To avoid probate, many individuals and married couples of means set up revocable trusts to hold valuable assets, including real property and bank and investment accounts. Once that trust no longer exists, make sure to get the income (and most likely the assets) out of the trust to avoid the onerous trust tax rates.

Here is good news. You receive inherited assets with a step-up in basis to fair market value at either the date of death or the alternate valuation date. If you sell shortly after inheriting, you likely will have a minimum, if any, taxable gain or loss.

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, the tax basis of the entire asset—not just the half that belonged to the decedent—is stepped up to fair market value.

The dreaded RMD rules generally apply to inherited IRAs and qualified plan balances. Beneficiaries cannot afford to ignore the RMD rules.

Parts of this article are published with permission from Bradford Tax Institute, © 2021 Daniel Morris, Morris + D’Angelo

Daniel Morris

Daniel frequently provides Media Content via Workshops, Podcasts, and Printed Articles on topics like Bitcoin and Cryptocurrency, Wealth Preservation and Planning, Global Banking, and many other high-level financial topics that serve and demonstrate the Value of our Global Network that should be of interest to those who need Private High-Wealth Services.

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