Federal tax issues

When a family member dies, the survivors need to address tax issues along with all the other legacies the deceased leaves behind. Both federal and state taxes may need attention, but the focus on this article is on federal tax issues.

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Filing a last tax return

A final income tax return needs to be filed on behalf of the deceased. The return is due on the same date of the year, after the taxpayer’s death, as other federal income tax returns. If there is an administrator or executor of the estate, that person usually files the final return. If no administrator or executor is named, then a survivor of the deceased can file the return. The filer uses the same form that the deceased would have used if still alive, but the word "deceased" is added after the name of the taxpayer.

Included income

The deceased’s final tax return should include only the income earned while the taxpayer was alive—from the first day of the tax year to the date of the taxpayer’s death.

Most taxpayers use the cash method of accounting, which counts income as it is received or made available to them. However, some taxpayers use another method of accounting—the accrual method. Under this method, income is counted when the person earns it, rather than when they receive it. The person filing the final return must know which accounting method the deceased used so they can report the correct amount of income on the return. Most all individual taxpayers use the cash method.

Inherited assets

If you inherit money from the deceased, it generally isn’t subject to the federal income tax. But if you inherit an interest-bearing asset, such as a certificate of deposit (CD), the interest it earns will be included taxable income.

For example, if you inherit a $100,000 CD, the $100,000 is not subject to taxation. However, you will need to include in income the interest the CD earns beginning from the time you own it. If you’ve received interest that accrued prior to the owner's death but was not paid, it is included on your return.

Retirement accounts you inherit

More and more people who started funding retirement accounts decades ago are leaving them behind as inheritances. Money in traditional individual retirement accounts, employer-sponsored retirement plans such as 401(k)s and 403(b)s, and annuities are treated differently than other inherited assets. They are considered income in respect of a decedent, meaning that they are included in the heir’s income.

An important exception to this is for Roth IRAs and Roth 401(k)s, provided the account has been open for at least five years prior to the owner’s death. In such cases, no taxes are due on Roth distributions you inherit. If the original account owner died before the 5-year period elapsed, you still can avoid taxes on the distributions. Simply roll the account over into an inherited Roth IRA and wait for the 5-year holding period to pass before withdrawing any funds.

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Claiming tax deductions

If you’re filing the deceased’s final tax return, you can itemize all deductible expenses that were paid prior to the taxpayer’s death. You can also deduct any medical bills that are paid within one year of the decedent’s death. These expenses may be treated as if the decedent paid them at the time they were incurred. Thanks to this rule, the entire cost of the decedent’s final illness can be deducted on his or her final return even though the bills weren’t actually paid until after death.

If you choose not to itemize deductions on the final return, you can claim the full standard deduction. It doesn’t matter when the taxpayer died. Even if the death occurred on January 1 of the tax year, you can still claim the full standard deduction.

Filing a joint final return

If the decedent was married at the time of death, a surviving spouse can file a joint return for the year the taxpayer died, regardless of when in the tax year they died. The widow or widower is allowed to claim the full standard deduction, just as though their spouse were alive, and they can use the joint-return tax rates.

Normally the executor will file the joint return, but if no administrator or executor has been appointed, the surviving spouse can file the return. The surviving spouse might also qualify as a widow or widower for the two years following his or her spouse's death. This allows a widow or widower who meets the requirements of a surviving spouse to continue using the same tax brackets as if filing a joint return.

If the surviving spouse is due a refund, he or she should file Form 1310, Statement of Person Claiming Refund Due a Deceased Taxpayer along with the final return. While the IRS states that a surviving spouse isn’t required to file Form 1310 along with a joint final return, it’s a good idea to file the form to avoid any possible delays.

The tax basis of property you inherit

Normally, when a person sells property, the tax on the sale is based on the appreciation that occurred since the property was owned. However, if you inherit a property and then sell it, the tax basis is "stepped up" to its value at the date of the person’s death. This means that the tax on the appreciation that occurred during the decedent’s life basically is forgiven. You would owe tax only on appreciation that takes place after the time of death.

Because of this rule, it’s essential to establish the date-of-death value of the inherited property as soon as possible. That way you can avoid hassles when you sell the property later. If an asset has lost value since the original owner acquired it, the property’s tax basis is stepped down to the value at the date of the person’s death.

Extending the home sale exclusion

Federal tax law allows a surviving spouse to exclude up to $500,000 of the profit from the sale of a home, just as a married couple can, rather than being limited to the $250,000 exclusion that single homeowners are allowed. However, the $500,000 exclusion is only available to the surviving spouse if the home is sold within two years of the spouse’s death.

If you've experienced a death in the family, let TurboTax guide you through the process of preparing the decedent’s final tax return.