If you’re like most people, the estate tax comes to mind when you think of estate planning. The state of California does not levy an estate tax. However, under federal law, there is an estate tax, as well as several other types of federal taxes that could impact your estate plan. We’ll discuss five of the most important federal taxes in this article.
1. Federal Income Taxes
We’ve all paid federal income taxes throughout our lives, but how do income taxes apply to an estate? As individuals, we file Form 1040 for our returns, whereas estates and irrevocable trusts file using Form 1041. More specifically, Form 1041 is filed by whoever is named the fiduciary of the estate and reports information about:
- The income, deductions, gains and losses of the estate or trust
- The income that is accumulated or held for future distribution or distributed currently to beneficiaries
- The estate’s or trust’s income tax liability, if any
- Wages paid to home staff and employees are subject to employment taxes
To be clear, we’re talking about an estate income tax return here. This is separate from the deceased person’s final personal income tax return.
An estate can generate income in several ways. Income-generating assets that may trigger the filing of an estate income tax return include:
- CDs
- Mutual funds, stocks, bonds
- Rental property
- Savings accounts
2. Federal Capital Gains Taxes
When you sell a piece of real estate or stocks, bonds or other securities, that can bring capital gains taxes into the picture. Capital gains rules are complex, but the basic notion is that you pay taxes on the profits you make from selling an asset. The profit is the sales price minus what you originally paid for the item. This purchase price is called your tax basis.
Here’s an example. When an estate sells a residence, the money is reported as income on Form 1041. The estate then takes a deduction for the amount allocated to heirs. The estate provides K-1s to the beneficiaries, who use the K-1 to record their part of the estate’s revenue and deductions.
While it’s possible that capital gains taxes could come into play on the sale of the home, it’s actually quite rare. When real estate is inherited, the property’s tax basis gets “stepped up.” This means the value is adjusted to its current market value. This step up often reduces or entirely eliminates the capital gains tax the beneficiary would have owed.
When an asset is sold for a profit, capital gains taxes may apply. It gets complicated by things like depreciation and capital improvements, which affect the final amount of capital gains tax owed. An attorney and accountant will help you sort through the labyrinth of capital gains rules that may apply to your personal situation.
3. Federal Estate Taxes
Estate taxes are paid only if the estate is worth more than a certain amount at the time of death. In 2022, the estate tax exemption is $12.06 million per person ($24.12 million for a married couple) – assuming United States citizenship. When you die, your estate is not taxed on anything under the exemption amount.
If your estate is worth more than the exemption amount, then your trustee or executor will work with a tax professional to prepare an estate tax return (Form 706) and pay the estate tax during the administration process. California doesn’t levy estate taxes at the state level and has not done so since 1981.
4. Federal Gift Taxes
A gift tax is a federal tax paid by a person who gives something of value to someone else. For 2022, you can give $16,000 each to as many people as you want without anyone having to report the gift to the IRS.
This is called the gift tax exemption. You can give the same person anything up to the exemption amount every single year without having to report it.
Whenever you gift more than that to someone, however, you are required to report the gift to the IRS. When you pass away, your federal estate tax exemption will be reduced dollar for dollar by the amount of reportable gifts you made during your life. So, if you report giving six million dollars in gifts during your life, your estate tax exemption would drop by that amount.
5. Generation-Skipping Taxes
You might think you can avoid estate taxes by leaving your assets to your grandchildren instead of to your children, but the IRS implemented the Generation-Skipping Tax to prevent that (GST). Also referred to as the generation-skipping transfer tax, the GST prevents you from deliberately skipping your children in your estate plan in favor of younger generations to bypass potential estate taxes due upon your children’s deaths.
In the end, the IRS receives an estate tax no matter which generation receives the inheritance. There is an exemption amount tied to the estate tax, with $12.06 million for 2022. Unless you give more than the GSTT exemption amount to a “skip-person” such as a grandchild, the tax isn’t imposed.
What About Inheritance Tax?
You probably noticed we haven’t mentioned inheritance taxes. That’s because there is no federal inheritance tax. People who inherit money are not taxed on it. Instead, the federal estate tax is imposed on the estate, not the people who inherit. In California, there is neither a state-level inheritance tax nor a state-level estate tax.
Get The Estate Planning And Tax Advice You Need
At the Law Office of Janet L. Brewer, we help people throughout the Bay Area create comprehensive estate plans that are effective and tax efficient. To schedule a consultation at our Los Altos office with our attorney and team, please call 650-325-8276 or contact us online anytime.
