Clients are frequently concerned about large taxes being assessed against an inheritance that their children receive. The fact is, less than 1% of Americans are subject to federal estate tax. Estates are subject to some other taxes, however.
Federal Estate Tax
The federal estate tax exemption in 2023 is $12.92 million, so every American can transfer $12.92 million in assets to their heirs without a dime paid in estate (transfer) taxes. In addition, a married taxpayer can transfer unlimited assets to a spouse without paying a estate tax. A married couple dying in 2023 can combine their exemptions using trusts or portability and transfer up to $25.84 million in assets to their heirs. Unfortunately, if the taxpayer transfers more than $12.92 million, or a couple transfers more than $25.84 million in assets, the remainder of his/her/their estate is taxed at 40% of the amount transferred.
State Estate Tax
While some states still have estate taxes (and many states have much lower exemptions than the federal exemption), Virginia has abolished the estate tax, and Virginians of any amount of wealth are exempt from state estate tax. If you live or own property in another state, you should seek legal advice from counsel in that state regarding whether you might be subject to state estate tax.
An often-overlooked tax on estates and trusts is the income tax. While an estate or trust is being administered, the estate or trust may generate income in the form of rent, dividends, interest, or other taxable income. If that income exceeds $600, the Executor or Trustee must file Form 1041, U.S. Income Tax Return for Estates and Trusts. To the extent that income is distributed out to the beneficiaries of the Estate or Trust, the Estate or Trust may be able to push that tax obligation out to the beneficiaries as well by issuing a K-1 to the beneficiary to report that income on his or her own taxes (and pay the taxes). While a beneficiary may not like having to pay taxes on the income on his or her inheritance, it actually benefits the beneficiaries of an estate or trust because estate and trust income tax rates are much higher than individual rates and thereby reduces the overall cost of the income taxes. Trusts and Estates reach the maximum tax rate of 37% for all income over $13,450 of income reported. Compare individuals pay 37% on all income over $578,125 (or all income over $693,750 for married taxpayers filing jointly). Form 1041 is complicated, and Executors and Trustees should retain an estate administration attorney or certified public accountant experienced in trust and estate income taxation to file this return.
Capital Gains tax is assessed on the difference between the fair market value of an asset and the taxpayer’s basis in the asset. Generally, outside of the estate area, if a person buys an asset, such as a house, for $100,000, that is their initial cost basis. The basis may increase or decrease, i.e. spending money on improvements will increase basis, while taking depreciation deductions will decrease basis. So, the person spends $25,000 on an addition, his basis increases to $125,000.00. If he later sells the property for $150,000, his capital gain is $25,000 and he will owe 15% or 20% of $25,000 as a capital gains tax, depending on his income. If he gifts it to his child during his lifetime instead, the child’s basis would be a transfer basis of $125,000, and if the child sold the property, the child would pay the tax.
If instead, the person dies when the property is worth $150,000, and leaves the property to his child via a Will or Revocable Living Trust, then the child’s basis is the fair market value as of the date of death. If the child sells it for $150,000, the child owes $0 capital gains tax. This is referred to as the “step-up in basis at death” even though you can actually have a step down in basis if the property goes down in value prior to death. If the child retains the property until it is worth $175,000, then the child would have a $25,000 gain ($175,000 Sales Price – $150,000 Date of Death Value Basis). Therefore, leaving this property to his child in his Will instead of a lifetime gift can save the child significant capital gains taxes.
Probate Assets are subject to the probate tax. There is both a Virginia state probate tax of 10¢ for every $100, or fraction thereof, of the value of the decedent’s estate. The locality (City or County) is then permitted to collect a probate tax of 1/3 of the state probate tax. The probate tax is imposed on probate estates with at least $15,000 in assets. For example, a $300,000 estate will pay $300.00 state probate tax and a $100.00 local probate tax for a total of $400.000 plus recording and qualification fees. The good news is that this is not vast sums of money. The even better news about probate taxes is that they are completely avoidable by use of probate avoidance estate planning techniques.
This is not an exhaustive list of taxes that an Executor or Trustee may encounter in administration, but they are the most common. An Estate or a Trust is a “person” for tax purposes and files its own returns. As this can be very complicated, an experienced estate administration attorney or certified public accountant should be engaged to navigate the complicated world of taxes in estate administration.