Death & Taxes

Death & Taxes – The only guarantees in life are death and taxes. Let us discuss the various taxes to be considered when a decedent dies.

The Federal Estate (Death) Tax applies very rarely. That is, when a decedent leaves an estate with a net value of over $5,400,000 to persons other than a surviving spouse. A decedent can leave an unlimited amount to a surviving spouse without Estate Taxes. In 2013, the US Supreme Court in the U.S. v. Windsor decision extended that protection to same sex couples. Married persons can effectively leave over $10,800,000 to their surviving loved ones by combining their individual Estate Tax exemptions.

While the Estate Tax rarely applies, it still has important Capital Gains income tax implications on every decedent’s estate. Capital Gains Tax is the income tax that is owed when one sells an asset for more than one’s income tax basis.   What is basis? Basis is your invested capital in an asset. Initially basis is determined by one’s purchase price. But basis can be adjusted upwards for improvements and downwards for income tax depreciation.

When one inherits an asset (other than a retirement plan) one receives a new adjusted basis equal to the asset’s appraised date of death value. Thus, if one inherits an appreciated asset the new basis in the hands of the recipient will wipe out all of the accumulated appreciation in value. This is a great tax savings opportunity and a reason why transferring assets at death (and not during life) to the surviving beneficiaries is advantageous.

Another place where federal and state Income taxes are involved is with “Income in Respect of a Decedent” (“IRD”). What is IRD? IRD is, “income that a decedent was entitled to receive that was not properly includable in his or her taxable income before death (Internal Revenue Code §691)”. Typical examples of IRD’s are a decedent’s earnings paid after death, retirement plan distributions, and dividends and interest that are received after the recipient’s death.

The obligation to pay the income tax due is on the decedent’s estate, the decedent’s trust, or the death beneficiaries, as relevant. Let’s discuss.

If the IRD is includable in the decedent’s estate, because it was paid to the decedent personally, then the decedent’s estate is liable to pay the federal and state taxes. Inside a probate such taxes are paid by the court appointed personal representative. If the decedent had a living trust, then the trustee would pay such debts. Otherwise, such tax liabilities will have to be paid by the beneficiaries or heirs from what they receive of the decedent’s untaxed IRD. One tax planning opportunity is to give items of IRD to tax exempt charities, such as, making one’s charity of choice the death beneficiary on an IRA.

Another tax to consider is the local real property taxes in each county where the decedent owns an interest in real property. In California the real property tax base (i.e., its value for computing real property tax owed) is adjusted (i.e., reassessed) to its current fair market value when there is a change in ownership, unless an exclusion from reassessment applies. The most important exclusions are those for real property transfers to a surviving spouse, or to a registered domestic partner, to a surviving child, and to a surviving grandchild where the parent is deceased.

A well drafted living trust takes all of these taxes into consideration in order to maximize tax savings and minimize tax costs. For example, a living trust will allow the trustee to allocate real properties to those children who want real property, allocate offsetting gifts of other assets to the other children, and encumber the subject real property to get loan proceeds used to equalize the gifts.