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Life Events and Taxes

Life is full of milestones. Its those significant events that we all go through at some point in our lives, like getting married, having a child, buying a home, a divorce, the death of a loved one, etc. Most of these events will affect not only our emotions and finances, but will also have significant tax implications that are often overlooked at the time of the event.

This section is devoted to providing tax information related to a variety of life events. It will be a useful guide that covers everything you need to know about the specific event that you are experiencing. It tells you what to expect, things to avoid, the possible consequences of making such a move, and different scenarios that may apply to the situation.

We hope that the information provided in this section will help you cope with any life event that comes your way and encourages you to seek professional assistance when necessary.

Inheritance Issues

When it comes to inheritances, there is considerable misunderstanding with taxpayers.  Many believe that inheritances are taxable.  That may or may not be true depending upon what is inherited. For example, if a taxpayer inherits cash, stocks and bonds, or real estate from a decedent, he or she is not taxed on these assets upon receipt (but income such as interest, dividends or rents generated from the inherited assets after the property is transferred to the taxpayer is reportable). On the other hand, if a Traditional IRA is inherited from a decedent (funds on which taxes were never paid by the decedent), the Traditional IRA will generally be taxable to the taxpayer; although, there will be certain options on when to take the taxable income. This discussion explains the role of an executor, the tax treatment for several types of assets that are frequently inherited, the rules regarding tax basis for inherited property, the tax reporting and associated forms likely to be encountered by beneficiaries, and who may claim the deduction when the decedent’s property is donated to charity. 

• Executor’s Duties and Compensation   
• Life Insurance 
• Beneficiary Tax Basis  
• Inherited IRAs   
• Inherited Personal Residence 
• Depreciable Assets  
• Income in Respect of a Decedent  
• Estate’s Income Tax Reporting   
• Donating Decedent’s Property to Charity

Executor’s Duties and Compensation 

Throughout most of this article, we refer to an “executor” of the estate. By legal definition, an executor is named in a decedent’s will to administer the estate and distribute the decedent’s property as the decedent directed. If no will exists, no executor was named in the will, or the named person cannot or will not serve as executor, a court will appoint an administrator, whose duties and responsibilities are generally the same as those of an executor. For estate tax purposes, the term executor can also include anyone in actual possession of the decedent’s property if no executor or administrator is appointed, qualified and acting within the U.S. A broad term that is sometimes used to describe an executor, administrator or other person who is in charge of the decedent’s property is personal representative. For simplicity, we’ll generally use “executor.”

The primary duties of an executor are to collect all of the decedent’s assets, pay creditors, and distribute the remaining assets to the heirs or other beneficiaries. Other specific duties of the executor include applying for an employer identification number (EIN) for the estate, timely filing required income and estate tax returns (including the decedent’s final Form 1040, plus Forms 1041 and 706 related to the estate), and paying the tax determined up to the date the executor is discharged from duties. The executor, who is oftentimes a friend or relative of the deceased individual, is not required to personally prepare the tax returns or legal documents needed to administer the estate, and generally will hire an attorney and professional tax preparer to assist in these matters. The fees charged by these professionals are paid from the assets of the estate.

Sometimes heirs or beneficiaries become impatient with the executor because they think that the administration of the decedent’s estate is moving too slowly. Beneficiaries need to realize that the executor must work within the timeframes of the courts and attorneys, especially when an estate has to go through the probate process. Additionally, the executor may need to delay the distribution of some or all of the estate’s assets until required tax returns are filed, taxes paid and tax clearances issued by the IRS. It is unusual for an estate to be completely settled in less than one year, and often it can take 18 to 24 months or longer.

Executors generally are eligible to receive compensation for their work, payable from the estate’s assets. In some states, the compensation is based on the value of the estate and may equal that paid to the attorney hired to take care of the estate’s legal matters. Thus, the executor’s fees can be several thousand dollars. All executors or other personal representatives who are compensated by an estate for their services must include those fees in their gross income on their personal tax returns. Professional executors or administrators must also pay self-employment tax on these fees. A person who serves as an executor or administrator in an isolated instance, such as a friend or relative of the decedent, pays self-employment tax on executor fees only if a trade or business is included in the estate’s assets, the executor actively participates in the business, and the fees are related to the operation of the business. If you are the executor of an estate and also the sole beneficiary, you may want to waive any executor fees. By doing so, the net amount of the estate’s assets that will pass to you will increase by the foregone fee, and you will not have to pay income tax on that amount. However, if the estate is subject to estate tax, this strategy may not be appropriate because the estate will lose the benefit of the executor fee deduction, and usually an estate’s tax bracket is higher than the beneficiary’s income tax bracket. Thus, there would be a greater net tax benefit if you receive the executor’s fee, pay tax on that income, and the estate takes a deduction for the fee.

Life Insurance

Life insurance proceeds that you receive because of the insured’s death are not taxable to you unless the policy was turned over to you for a price. This applies even if the proceeds are paid under an accident or health insurance policy or an endowment contract. If the proceeds are received in installments, part of each installment is excludable from your income. The excludable part is figured by dividing the amount held by the insurance company – usually the lump-sum payable at the insured person’s death – by the number of installments to be paid. The portion that is not excludable is taxable as interest income.

Beneficiary Tax Basis

Basis is a tax term that defines the amount of a taxpayer’s investment in a property. For property that is purchased, the initial tax basis is the cost of the property, but that basis can be adjusted up or down by events that occur after the property is acquired. Basis is used for figuring depreciation (on business property) and is the dollar value from which a taxpayer measures his gain or loss when an asset is sold.  Generally, when you inherit an asset from a deceased individual’s estate or trust, you receive the asset at its fair market value (FMV) determined as of the individual’s date of death.  The inherited basis can be more or less than what the decedent paid for the property.  This change in basis is sometimes referred to as a step-up or step-down in basis.  Thus, if for example, you inherited 100 shares of stock that the decedent originally purchased for $40 a share (total cost $4,000) that is worth $100 per share (total value $10,000) when the decedent died, you will receive the stock free of any income tax and will have an inherited basis of $10,000.  Any future gain or loss will be measured from the $10,000 basis.

As is the case with property that is purchased, the basis of inherited property may have to be adjusted during the beneficiary’s ownership period. Situations that require basis adjustment include stock splits, nontaxable dividend distributions, improvements to real property, and casualty losses, among others. The important point is that, for property acquired from a decedent, the starting place for making any required adjustments is the initial inherited basis.

CAUTION 2010: Legislation enacted nearly 10 years ago repeals the estate tax for individuals dying in 2010, and then brings it back for those dying after 2010.  Although many had thought Congress would revoke the repeal for 2010 and keep the tax at 2009’s level that has not happened yet.  Without Congressional action (there are active legislative discussions taking place), the basis for items inherited in 2010 will be based upon a more complicated “modified carryover basis”.  Thus, for 2010, inherited basis becomes the lesser of the  decedent’s adjusted basis, or the FMV at the date of death plus an allowable aggregate basis increase of $1,300,000 plus loss carryovers and built in losses, and if applicable a spousal $3,000,000 property basis increase.

Joint Ownership - A beneficiary who is a joint owner of a property with the decedent will have a basis made up of two parts: his or her own basis for the original ownership portion and an inherited basis for the part that was inherited. For example, a father and son each owned 50% of a lot they purchased together for $10,000 several years ago.  At the time of the father’s death in 2009, the lot was worth $20,000 and the son was the beneficiary of the father’s share of ownership. The son’s new basis in the property is $15,000 (50% of $10,000 plus 50% of $20,000).    

Community Property - A husband and wife who are residents of a community property state* generally are considered to each own half of the community property. At the death of either spouse, the total value of the community property – even the surviving spouse’s part – becomes the basis of the entire property. This rule applies when at least half the value of the community property interest is includible in the decedent’s gross estate, whether or not the estate must file a return. For example, a husband and wife owned community property that had an adjusted basis of $100,000 at the time the husband died in 2009. The fair market value at his date of death was $150,000, and half the FMV was includible in the husband’s estate. The husband’s will named his sister as the beneficiary of his half of the property. The wife and the sister will each have an inherited basis of $75,000. If the wife was the sole beneficiary, her new basis as of the husband’s date of death would be $150,000.

*Community property states are Alaska (by election), Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin.

Valuation Other than at Date of Death – Under some circumstances, the executor of the decedent’s estate may choose to use the fair market value on the “alternate valuation date” instead of the decedent’s date of death. The alternate valuation date is the date six months after the date of death. This alternate date is chosen when using the values of all assets in the estate at that date will produce a lower estate tax than when the date of death valuation is used. While using the alternate valuation saves estate tax, it means that the beneficiary’s basis of inherited property will be lower than if the date of death valuation applied. Thus, when the beneficiary sells the inherited property in the future, his or her gain will be more (or the loss will be less) than if the date of death FMV applied. The beneficiary is required to use the same basis that the executor used for the estate tax return. The executor should provide a record of the inherited basis for each asset the beneficiary receives, regardless of which valuation date is used. Note: The beneficiary’s basis in assets inherited from a decedent dying in 2010 is determined by a different set of rules.  See CAUTION 2010 above.

Holding Period of Inherited Property – Gains from the sale of capital assets such as stocks, bonds, unimproved real estate, etc., that are held “long-term” are given beneficial tax treatment. This special treatment is in the form of lower tax rates. To qualify as long-term, generally an asset has to be held more than one year. An exception is made for inherited assets, which automatically receive long-term treatment regardless of how long the decedent or the beneficiary owned the property. Note: The beneficiary’s holding period in assets inherited from a decedent dying in 2010 may be determined differently if the decedent’s basis is carried over.  See CAUTION 2010 above.

Inherited IRAs 

A number of factors are involved in determining how much, if any, of an IRA account that you inherit is taxable to you, and when the taxable amount is includible in your income. These factors include which type of IRA (Traditional or Roth) is inherited, who the beneficiaries are (spouse, non-spouse, trust or estate), the deceased IRA account owner’s age at death, and whether or not distributions from the IRA were required to start before the decedent’s death. With a Traditional IRA, the account owner is required to begin taking annual minimum distributions by April 1 of the year following the year in which he or she reaches age 70½. Roth IRA account owners are not required to take distributions during their lifetimes. The following situations explain the options available to beneficiaries of these IRAs.

Traditional IRA inherited by spouse and decedent owner was under 70½: – If the spouse takes a distribution of the IRA account as a lump-sum, the spouse will pay income tax on the distribution on the tax return for the year of the distribution, but no penalty for “early” withdrawal will be due, even if the spouse is under age 59½.

• Transfer to spouse’s own existing or new IRA – This choice is available only if the spouse is the sole beneficiary of the IRA. If the deceased account owner had not already taken the required minimum distribution (RMD) for the year of death, the spouse must do so. A spouse who is under age 59½ is regulated by the same distribution rules as if the IRA had been his or hers originally, so distributions cannot be taken before age 59½ without incurring the 10% penalty (except for the required year-of-death RMD or if one of the general exceptions applies).

• Transfer to Inherited IRA held in own name – The annual RMD based on life expectancy must begin no later than December 31 of the year following the original account owner’s death. Also, if no RMD had been taken by the decedent in the year of death, an RMD must be taken from the Inherited IRA by December 31 of the year the original account owner died. The annual distributions are spread over the longer of the surviving spouse’s single life expectancy using his or her age in the calendar year following the year of death and refigured each year, or the deceased account owner’s remaining life expectancy. Each distribution is taxed, but the 10% early distribution penalty does not apply. If there are other beneficiaries besides the spouse, separate accounts must be established by the end of the year following the year of death; otherwise, distributions will be based on the life expectancy of the oldest beneficiary, which will cause the amount of the distribution to be greater than otherwise required for the younger beneficiaries.  

Traditional IRA inherited by spouse and decedent owner was 70½ or older:

• Lump-sum distribution – Same result as for a decedent who was under 70½ (see above).

• Transfer to spouse’s own existing or new IRA – This choice is available only if the spouse is the sole beneficiary of the IRA. If the deceased account owner had not already taken the required minimum distribution (RMD) for the year of death, the spouse must do so. A spouse who is under age 59½ is regulated by the same distribution rules as if the IRA had been his or hers originally, so distributions cannot be taken before age 59½ without incurring the 10% penalty (except for the required year-of-death RMD or if one of the general exceptions applies).

• Transfer to Inherited IRA held in own name – The annual RMD based on life expectancy must begin no later than December 31 of the year following the original account owner’s death. Also, if no RMD had been taken by the decedent in the year of death, an RMD must be taken from the Inherited IRA by December 31 of the year the original account owner died. The annual distributions are spread over the longer of the surviving spouse’s single life expectancy using his or her age in the calendar year following the year of death and refigured each year, or the deceased account owner’s remaining life expectancy. Each distribution is taxed, but the 10% early distribution penalty does not apply. If there are other beneficiaries besides the spouse, separate accounts must be established by the end of the year following the year of death; otherwise, distributions will be based on the life expectancy of the oldest beneficiary, which will cause the amount of the distribution to be greater than otherwise required for the younger beneficiaries. 


Traditional IRA inherited by non-spouse and decedent owner was under 70½:

• Lump-sum distribution – Same result as if the spouse was beneficiary (see above).

• Transfer to Inherited IRA held in own name, 5-year withdrawal – Distribution can be spread over time, but all of the assets in the account need to be distributed by December 31 of the fifth year after the year in which the account owner died. Distributions are taxed as received, but are not subject to the 10% early withdrawal penalty.

• Transfer to Inherited IRA held in own name, distributions over life expectancy – A required minimum distribution based on the beneficiary’s life expectancy must begin no later than December 31 of the year following the year of the original account owner’s death. The annual distributions are spread over the beneficiary’s single life expectancy based on his or her age in the calendar year following the year of death and reduced by one each year thereafter. If there are multiple beneficiaries, separate accounts should be established by December 31 of the year following the year of death in order for each beneficiary to use his or her own life expectancy. Otherwise, life expectancy is based on that of the oldest beneficiary. Each distribution is taxed, but the 10% early distribution penalty does not apply.

Traditional IRA inherited by non-spouse and decedent owner was age 70½ or older:

• Lump-sum distribution – Same result as if the spouse was beneficiary (see above).

• Transfer to Inherited IRA held in own name - The annual RMD based on life expectancy must begin no later than December 31 of the year following the original account owner’s death. Also, if no RMD had been taken by the decedent in the year of death, an RMD must be taken from the Inherited IRA by December 31 of the year the original account owner died. The annual distributions are spread over the longer of the beneficiary’s single life expectancy using his or her age in the calendar year following the year of death and reduced by one each year, or the deceased account owner’s remaining life expectancy. If there are multiple beneficiaries, separate accounts should be established by December 31 of the year following the year of death in order for each beneficiary to use his or her own life expectancy. Otherwise, life expectancy is based on that of the oldest beneficiary. Each distribution is taxed, but the 10% early distribution penalty does not apply.

Traditional IRA with Basis – Generally, while the account owner was alive, he or she would have deducted the contributions made to a Traditional IRA on the income tax returns for the years of the contributions. However, if the taxpayer participated in an employer’s retirement plan and was not eligible to deduct IRA contributions because of income limitations, he or she was still allowed to contribute to the IRA but had to designate the contribution as being nondeductible. In this situation, the nondeductible contribution amounts became the taxpayer’s basis in the IRA, since tax had already been paid on the funds used to make the contributions. If you inherit a traditional IRA from a person who had a basis in the IRA because of nondeductible contributions, that basis remains with the IRA. This means that each distribution you take from the inherited IRA will be partly nontaxable. Unless you are the decedent’s spouse and choose to treat the IRA as your own, you cannot combine this basis with any basis you have in your own Traditional IRAs or others you may have inherited. Form 8606 is used to figure your taxable and nontaxable portions of the IRA distribution. How will you know what the decedent’s IRA basis is? This information can be found on the Forms 8606 the decedent filed with his or her tax returns. The executor for the decedent’s estate should have access to that information and should make it available to you as the beneficiary of the IRA.

Federal Estate Tax Deduction – A beneficiary may be able to claim a deduction for estate tax resulting from certain distributions from a Traditional IRA. The beneficiary can deduct the estate tax paid on any part of a distribution that is income in respect of a decedent, which includes IRAs. The deduction is taken for the tax year the income is reported. See more about income in respect of a decedent below.

Roth IRAs – Roth IRAs are not subject to the annual required minimum distribution rules during the account owner’s lifetime. But after the owner’s death, distributions may need to be made. Roth IRA distributions, whether to a living owner or a beneficiary, are made up of after-tax contributions and earnings. Contribution amounts are always distributed tax-free, while earnings may or may not be taxable. If the Roth account was open for at least five years at the time the account owner died, earnings are distributed tax- and penalty-free. If the earnings are distributed before the account has been open for 5 years, the earnings are taxable, but penalty-free. (The IRS has specific “ordering” rules that determine how much of a distribution consists of contributions or earnings.) If the beneficiary chooses not to take a lump-sum distribution of the Roth IRA, the remaining distribution choices are as follows:

• Spousal transfer - A spouse who is the sole beneficiary of a Roth IRA may transfer the assets into his or her own existing or new Roth IRA and is then regulated by the same rules as if the IRA had been his or hers originally. Distributions of earnings will be taxable until the spouse reaches age 59½ and the account is at least five years old. Under this arrangement, the spouse is not required to take distributions from the Roth IRA while living.

• Inherited IRA, 5-year withdrawal – The assets are transferred into an Inherited IRA held in the beneficiary’s name. Distributions can be spread over time, but all assets must be withdrawn by December 31 of the fifth year after the year in which the account owner died. If distributions are taken during the five-year, post-death period, they will not be taxed provided that the five-year account holding period has been met.

• Inherited IRA, life expectancy withdrawal – Assets are transferred into an Inherited Roth IRA held in the beneficiary’s name. For non-spouse beneficiaries, distributions must begin no later than December 31 of the year following the year of death and are spread over the beneficiary’s single life expectancy. A spouse who is the sole beneficiary has the option of postponing distributions until the decedent would have reached age 70½, if later. If there are multiple beneficiaries, they need to establish separate accounts by December 31 of the year following the year of death in order to use their own single life expectancies. The 10% early withdrawal penalty does not apply.

Trust or Estate as Beneficiary – Special rules apply when the IRA beneficiary is a trust or an estate, and are beyond the scope of this discussion.  

Inherited Personal Residence

Individuals are allowed to exclude gain on the sale of their personal residence if they have owned and used (lived in) the property as their principal residence for two years during the five years immediately prior to its sale. The exclusion is limited to $250,000 ($500,000 for taxpayers filing a joint return where either spouse meets the ownership test and both meet the use test). If the sale of a personal residence, or any other personal-use property, results in a loss, the loss is not deductible. The rules when a personal residence is inherited are as follows:

• Basis and holding period – The basis of the property will be the fair market value at the date of the owner’s death or the alternate valuation date, if it is chosen by the executor or personal representative. The holding period is automatically long-term.  But see "Caution" above for deaths after 2009.

• Use of exclusion by non-spouse beneficiary – If a non-spouse beneficiary inherits what had been the personal residence of the decedent, and then sells the property, generally the home sale gain exclusion will not apply because the beneficiary won’t meet the 2-of-5 years’ ownership and use tests. If the beneficiary moves into the home, and then uses it as his or her own personal residence, the gain exclusion can be claimed if the 2-of-5 years’ tests are met when the home is sold.  (Note: A law change currently on the books and effective for property acquired from a decedent dying during 2010, will entitle a beneficiary to the home sale gain exclusion, determined by taking into account the decedent’s ownership and use.)

• Surviving spouse sells at gain – In most cases, the surviving spouse will inherit the home in which the couple lived. It’s not unusual for the surviving spouse to sell the home within a short period of the decedent’s death, in order to downsize, move closer to family, or go into a retirement facility. In the case of an unmarried individual whose spouse is deceased on the date of the sale of the home, the period the surviving spouse owned and used the property includes the period the deceased spouse owned and used the property before his or her death. This provision benefits a surviving spouse who was only recently married to the decedent who had been the home’s owner or in cases where the decedent had sole title to the home.

A surviving spouse (who is unmarried) qualifies for the up-to-$500,000 exclusion if the home is sold no later than the second anniversary of the spouse’s death and either spouse meets the ownership and use requirements. Absent this rule, the surviving spouse would be limited to an exclusion of $250,000 unless the home was sold in the year of death. However, it would be an unusual circumstance in today’s housing market for even a $250,000 exclusion to be too little to cover the gain for a home sold within two years of the spouse’s death, considering the basis step-up the surviving spouse likely received.

• Loss allowed on sale of inherited home  – A beneficiary who inherits the residence of a decedent, and who sells the property soon thereafter, may sell it for close to the appraised value as of the date of death, which would result in little gain or loss. However, the beneficiary will usually sell the residence through a broker and will have substantial sales costs. These sales costs quite often translate into a large loss on the sale. Normally, the loss upon a sale of a personal residence is not deductible. However, the courts have ruled favorably for beneficiaries selling inherited residences at a loss, allowing a capital loss where the beneficiary immediately attempts to rent or sell the property, or where a beneficiary who was living in the house at the decedent’s death, moves out as soon as other quarters are located. The character of the property has changed from being personal-use property, which it was to the decedent, to investment property of the beneficiary, thus qualifying for a long-term capital loss if sold at a loss.

Depreciable Assets

Depreciation is one of the “events” that affects basis; when a taxpayer has recovered part of his or her investment through a depreciation deduction, the basis must be reduced by the amount of the deduction. However, if you inherit property that the decedent had been depreciating (because he or she had used it in a business or rental activity), the inherited basis of the property may or may not be affected by the prior depreciation that was claimed. If the decedent was the sole owner of the property and died prior to 2010, the inherited basis is the full fair market value at the date of death (or the alternate valuation date, if applicable) – that is, no adjustment is required for the depreciation allowed while the decedent was alive. The inherited basis from decedents dying in 2010 is determined by a more complicated set of rules (see CAUTION 2010 earlier in this article). If the property continues to be used for business or rental purposes, depreciation starts anew based upon the inherited basis.

As explained above under “Beneficiary Tax Basis,” when the decedent had jointly owned the property with another individual, the post-death basis is made up of two parts; the surviving tenant’s part of the original basis plus the value of the portion of the property included in the decedent’s estate. For depreciated property, the combined new basis is also reduced by the depreciation that had been allowed to the surviving tenant; the decedent’s previously claimed depreciation is ignored. For example, Mother and Son invested $60,000 each for a rental property that they owned as joint tenants with the right of survivorship. Up to the date of Mother’s death, depreciation of $20,000 had been claimed. The fair market value at Mother’s date of death was $200,000. The inherited basis of the property is $150,000 ((50% x $120,000) (50% x $200,000) - (50% x $20,000)).

If the beneficiary and the decedent jointly owned the property, and the beneficiary continues to use the property for business or rental purposes after the co-owner’s death, the beneficiary continues depreciating his or her adjusted basis under the same method used in previous years. Depreciation on the part of the basis inherited from the decedent starts anew as of the date of death using the modified accelerated recovery system (MACRS).

A surviving spouse who inherits community property from his or her deceased spouse that was used for business or rental purposes does not reduce the inherited basis by any portion of the depreciation attributable to the period prior to the spouse’s death. The entire new basis (less any land portion if the property is real estate) is depreciable.

Income in Respect of a Decedent

Income a decedent would have received had he or she not died but that was not includible on the decedent’s final income tax return (because it had not been received) is called “income in respect of a decedent” (IRD). Examples of IRD are wages and other compensation for personal services earned but not yet paid as of the date of death; amounts due and owing based on the sale of farm crops or livestock; unpaid interest, investment income, rents and royalties; income from pass-through entities such as partnerships; post-death payments on pre-death installment sales; taxable portion of inherited IRAs; and Roth IRAs to the extent earnings are taxable.

Deductions in Respect of a Decedent – Business expenses, income-producing expenses, interest and taxes for which the decedent was liable but that weren’t properly allowable as a deduction on the decedent’s final income tax return are deductible, when paid, by the beneficiary of the property if the estate wasn’t liable for the obligation.

Estate Tax Deduction Mitigates Double Taxation - Income in respect of a decedent is included in the decedent’s estate tax return and then also becomes taxable for income tax purposes when it is later collected by the estate or beneficiary. If estate tax was paid on this income, an income tax deduction is allowed to the IRD recipient for the estate tax paid on the income. The deduction is claimed only for the same tax year in which the IRD must be included in the recipient’s income. An individual claims the deduction as a miscellaneous itemized deduction, not subject to the 2% of AGI limit, and it is also allowed as a deduction for alternative minimum tax purposes.  If you are a beneficiary who is required to include IRD in your income, you should be sure to obtain a copy of the estate’s Form 706 from the executor so that you or your tax return preparer will have all of the information necessary to calculate the estate tax deduction.

Estate’s Income Tax Reporting

During the period from an individual’s date of death until that individual’s assets have all been passed into the hands of the heirs and beneficiaries, income earned by those assets must be accounted for by the estate (or trust if so established by the decedent’s will or a trust agreement).  The estate is a taxable entity separate from the decedent; it comes into existence upon the death of the decedent and lasts until all of the assets have been distributed to the heirs and beneficiaries.

Like an individual, an estate must file an annual income tax return (Form 1041) if its income exceeds a filing threshold amount (currently $600).  The executor has the option of using a month ending other than December 31 as the end of the estate’s tax year. (Generally, trust returns must have a December 31 year-end, but under some circumstances the trustee can elect to have the trust treated like an estate and use other than a calendar year-end.)

Who Pays the Income Tax? The income tax liability of an estate attaches to the assets of the estate. If the income is distributed, or must be distributed, during the current tax year, the income is reportable by each beneficiary on his or her individual income tax return. But if the income does not have to be distributed, and is not distributed but is instead retained by the estate, the income tax on the income is payable by the estate. Should the income be distributed later without the tax having been paid, the beneficiary can be liable for the tax to the extent of the value of the estate’s assets received. The estate’s income is taxed either to the estate or the beneficiary, but not both. Other than in the final year of the estate, when the beneficiaries must report any taxable income, it is generally at the executor’s option whether the income is distributed to the beneficiaries. Recipients of “specific bequests” generally do not have to pay tax on any portion of the income earned by the estate. These concepts are illustrated in the following example:

Example: Father died on June 30, 2008. Per his will, Cousin is to receive $10,000, and after paying any estate tax liability, funeral expenses, last-illness expenses, and other debts, his Daughter and Son each are to receive 50% of the remaining estate. Father’s estate consisted of savings accounts and stocks (no real estate). The executor of the estate selected a year-end of January 31, 2009. During the period from Father’s death through January 2009, the assets of the estate earned $5,000 of interest income and $2,000 of stock dividends. Neither this income nor any of the estate’s assets were distributed to Cousin, Daughter or Son by January 31. The executor must file a Form 1041 that reports the $7,000 of income and will pay the tax on that income from the assets of the estate. After getting the probate court’s approval to distribute the assets of the estate, the executor does so on July 31, 2009. The interest and dividend income earned from February 1 through the date of distribution is $6,000. Since the estate’s assets, and income earned since Father’s death, are passed on to Daughter and Son, they would each be responsible to include $3,000 of income on their individual returns. Cousin receives $10,000 from the estate, but does not receive any of the income, and thus pays no tax on it. The executor will file a final Form 1041 Income Tax Return for the estate for the period February 1, 2009 through July 31, 2009. This return will show that the income has been distributed to the beneficiaries and is not taxable to the estate.

Commonly, the executor will pay attorney fees and other expenses during the last tax year of the estate. If these expenses have not already been claimed on the Estate Tax Return, they can be used to offset the income earned during the same period. If the expenses exceed the income, the excess deduction is passed on to the beneficiaries to use on their income tax returns. In that case, none of the income earned during the final reporting period is taxable to the beneficiaries. The final-year excess estate deductions are deductible on each beneficiary’s individual income tax return as a miscellaneous itemized deduction subject to the 2%-of-AGI limitation.

Form 1041, Schedule K-1 – When distributions are made to the beneficiaries, the amount of income or deductions reportable by each beneficiary on their own Form 1040 is shown on Schedule K-1 of the estate’s income tax return, Form 1041. The executor is required to provide each beneficiary a copy of his or her Schedule K-1 by the date the Form 1041 is filed. For the K-1s to be accurately completed, each beneficiary is required to provide their taxpayer identification number (Social Security number) to the executor. In the example above, Daughter and Son would each receive a K-1 from the executor, but no K-1 would be prepared for Cousin.

Donating Decedent’s Property to Charity

Generally, an individual will leave instructions to the estate executor in his or her will as to the desired disposition of personal property owned by the decedent at death. This may include identifying specific items to go to specific individuals, or that all of the decedent’s personal property is to be divided amongst the heirs, or that it should be disposed of as seen fit by the executor. Often, the property ends up being donated to a charity.  These post-death donations are not deductible on the decedent’s final income tax return, and do not qualify to be deducted on the estate tax return unless the decedent’s will identified the charity to which the donation was to be made.

If you received personal property from a decedent’s estate and then donated it to a qualified charitable organization, you may be able to claim a charitable deduction as an itemized deduction on your income tax return.  The value (basis) of the contributed property for the purpose of calculating the deduction will be the fair market value of the property as of the decedent’s date of death (or alternate valuation date, if applicable).  Caution: In the case of decedents dying in 2010 the value may not be the FMV and instead may be some other value as determined in the estate under complicated rules that apply to 2010 (See CAUTION 2010 earlier in this article). The executor, when making an inventory of the decedent’s assets, should also have determined the inherited value of the personal property, so you may need to confer with the executor to obtain this information. The IRS has stringent rules related to non-cash donations, which are summarized next.

Deductions of Less Than $250 – If you claim a non-cash contribution for donation to a qualified organization of property such as used clothing or furniture with a value less than $250, you must get and keep a receipt from the charitable organization showing:

1.  The name of the charitable organization,
2.  The date and location of the charitable contribution, and
3.  A reasonably detailed description of the property that was donated.

However, you are not required to have a receipt where it is impractical to get one, such as when the property was left at a charity’s unattended drop site.

Deductions of At Least $250 But Not More Than $500 - If you claim a deduction of at least $250 but not more than $500 for a non-cash charitable contribution, you must have and keep an acknowledgment of the contribution from the qualified organization. If the contributions were made by more than one contribution of $250 or more, you must have either a separate acknowledgment for each or one acknowledgment that shows the total contribution.  The acknowledgment(s) must be written and include:

1.  The name of the charitable organization,
2.  The date and location of the charitable contribution,
3.  A reasonably detailed description (but not necessarily the value) of any property contributed,
4.   Whether or not the qualified organization gave you any goods or services as a result of the contribution (other than certain token items and membership benefits), and
5.   If goods and or services were provided to you, the acknowledgement must include a description and good faith estimate of the value of those goods or services.  If the only benefit received was an intangible religious benefit (such as admission to a religious ceremony), that generally is not sold in a commercial transaction outside the donative context, the acknowledgment must say so and does not need to describe or estimate the value of the benefit.

Deductions Over $500 But Not Over $5,000 - If you claim a deduction over $500 but not over $5,000 for a non-cash charitable contribution, you must have the same acknowledgement and written records as for contributions of at least $250 but not more than $500 described above.   In addition, the records must also include:

o How the property was obtained.  For example, by purchase, gift, bequest, inheritance or exchange.
o The approximate date the property was obtained or, if created, produced, or manufactured by the taxpayer, the approximate date the property was substantially completed. (For property acquired from a decedent, this is the date of death, not the date that you actually gained physical control of the property.)
o The cost or other basis, and any adjustments to the basis, of property held less than 12 months and, if available, the cost or other basis of property held 12 months or more. (Generally, this will be the inherited value of the property at the date of death of the decedent, unless the alternate valuation date is used for estate tax purposes. If you have made improvements to the property, increase the inherited basis by your costs.)

Deductions Over $5,000 –Special rules apply related to contributions over $5,000; please confer with your tax advisor regarding the documentation requirements for the particular contribution before making the contribution.

With the exception of vehicle contributions (see below), charitable gift acknowledgements must be obtained before the earlier of the date you file your return for the year you make the contribution, or the due date, including extensions, for filing your return.

Additional Rules - Besides the recordkeeping and reporting rules noted above, the IRS has additional requirements when used vehicles, clothing or household items are donated:

• Vehicle Donations - The deduction for motor vehicles for which the claimed value exceeds $500 is dependent on the charity’s use of the vehicle. If the charity sells the vehicle, generally the donor’s charitable deduction is limited to the amount of the gross proceeds from the charity’s sale.

When the deduction claimed for a donated vehicle (car, boat, plane) exceeds $500, IRS Form 1098-C (or other statement containing the same information as Form 1098-C) furnished by the charitable organization must be attached to the filed tax return.  Without the 1098-C or other statement, no deduction is allowed. When the charity sells the vehicle, the Form 1098-C (or other statement) must be obtained within 30 days of the sale of the vehicle. Otherwise, the Form 1098-C (or other statement) must be obtained within 30 days of the donation.

• Clothing and Household Goods Contributions - No deduction is allowed for a charitable contribution of clothing or household items unless the clothing or household item is in:
o Good used condition, or
o Better.

In addition, the IRS may deny a deduction for any item with minimal monetary value, such as used socks or undergarments. A deduction may be allowed for a charitable contribution of an item of clothing or a household item not in good used condition or better if the amount claimed for the item is:
o More than $500, and
o You include with your return a qualified appraisal with respect to the property.

• Household Items - Includes furniture, furnishings, electronics, appliances, linens, and other similar items.  Food, paintings, antiques, and other objects of art, jewelry and gems, and collections are excluded from the provision.

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