When a Loved One Passes Away

Over the last few months, I have lost one of my clients to COVID-19 and added a new client who lost their father to the virus. Both the surviving spouse and the daughter had questions about what to do or what needs to be done when a loved one passes. I thought I would take a moment and highlight some of the important considerations.

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.
 
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.
 
Filing Tax Returns. You, as the executor, may need to file
 

• the decedent’s final Form 1040,
• the estate’s Form 1041 income tax return, and
• the estate’s Form 706.

 
You won’t need to file Form 1041 when all the decedent’s income-producing assets bypass probate and go straight to the surviving spouse or other heirs by contract or by operation of law—assets such as
 

• real property that is owned by joint tenants with right of survivorship,
• qualified retirement plan accounts and IRAs that have designated account beneficiaries, and
• life insurance death benefits that are paid directly to designated policy beneficiaries.

 
If the estate is valued at $11.58 million or less and the decedent did not make any sizable gifts before death, you don’t have to file Form 706. But even if you don’t have to file Form 706, you may want to file it anyway to preserve the portability election.
 
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.
 
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.
 
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
 

• the decedent’s date of death, or
• 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.
 
You should work with brokers to update basis information of stocks and bonds and may need to obtain appraisals of real estate or other assets to support the step-up basis.
 
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 only owe federal capital gains tax on the appreciation (if any) that occurs after the applicable magic date. That means little or no tax may be owed. Good!
 
Medical Expenses of the Decedent. The decedent’s medical expenses provide you with planning opportunities to
 

• deduct as itemized deductions (subject to the 7.5 percent floor) not only the medical expenses incurred during the taxable year of death, but also those unpaid at the date of death but paid within one year of death; or
• deduct in full (no floor) the medical expenses paid after the date of death against the federal estate tax.

 
Life Insurance Proceeds. In general, life insurance proceeds paid to beneficiaries of the policy are not taxable to the beneficiaries.
 
Inheritance and Tax. In most cases, if an asset has already been taxed then the beneficiaries will not owe tax on the inheritance. If the asset has not yet been taxed, such as IRAs and retirement accounts, the beneficiaries will need to pay tax on the distributions they receive when received. If the assets represent income of the estate and are distributed to the beneficiaries, the beneficiaries will need to pay tax on that distributed income. Some states may have an inheritance tax that will be owed even if there isn’t an imposed federal tax.