When property is transferred to an heir after the passing away of the original owner, federal inheritance tax is paid. Also known as estate taxes, inheritance taxes are calculated based on the fair market value of the property transferred to the beneficiary of the estate.
The tax code of different countries may make reference to inheritance tax, estate tax, and even a "death duty." In the United States, there is a difference between estate and inheritance taxes. Estate taxes are levied on representatives of the deceased person, while inheritance taxes are levied on the beneficiaries of an estate. Elsewhere in the world, these terms are used interchangeably.
Under the current law, the IRS has a prescribed method for determining if any tax is due on property or monies received. This method will be described briefly in the section below. The settling of an estate is a complex matter. An attorney or accountant should be consulted in situations that involve matters of the law. This is especially true when contesting a Will, known as the probate process, is concerned.
The first step used to determine the tax due is to calculate the fair market value of the entire estate. This would include cash, bank accounts, stocks and bonds, real estate, insurance, and similar items of value. The total fair market value of all these items is termed the Gross Estate.
The next step is to calculate any adjustments to the gross estate. Typical adjustments include paying-off the remaining balance on a mortgage, or the fees associated with settling the estate. This can include costs such as estate administration fees or payments made to an attorney. Finally, there is also a Marital Deduction that can be taken for property left to a surviving spouse.
Once all the deductions have been taken from the gross estate, the remaining balance is considered the net value of the property, or the inheritance tax basis. To calculate whether or not any inheritance tax is due; the net value of the property must be subtracted from the inheritance tax credits appearing in the tables below. If the net estate is larger than the tax exclusion, then federal income taxes are due at the estate and gift tax rates described below.
Life insurance proceeds paid to an heir are used in the calculation of the gross estate. The value of any insurance received is subject to the unified credits and inheritance tax exemptions explained later on. This last statement is true if the beneficiary elects to receive the proceeds in the form of a single lump sum.
If the life insurance proceeds are received in installments, the value of the insurance inherited needs to be separated from the total of all the installment payments to determine the federal tax liability. For example, the beneficiary of the policy may be able to elect to receive a lump sum of $100,000, or $10,000 per month for 12 months. The difference between the lump sum payment, and the money received over time, is due to interest earned on the policy by taking installments.
In this example, the beneficiary is receiving a total of 12 x $10,000 or $120,000, which is $20,000 higher than the lump sum of $100,000. Income tax is owed on the $20,000 received in the form of interest income.
The Unified Credit is used to eliminate or reduce an individual's tax liability. The credit applies to both gifts that may have been given and estates that will be inherited. It is termed a lifetime credit because as each gift is given or an estate inherited, the credit is consumed. The lifetime credit applies to all inheritance or gifts received since 1977.
As of January 1, 2013, the American Taxpayer Relief Act of 2012, or ATRA, increased the estate and gift tax rate from 35 to 40%. The estate tax exclusion continues to be indexed for inflation and increases to $11.70 million in 2021. The annual gift tax exclusion, lifetime estate / inheritance tax exclusion, and the unified tax credit for the years 2004 through 2021 appear in the table below:
|Year||Gift Tax Exclusion||Estate or Inheritance Tax Exclusion||Unified Credit|
|2006, 2007, 2008||$12,000||$2,000,000||$330,800|
The annual gift tax exclusion applies to each person receiving a gift. Married couples can each provide gifts to the same person. For example, in the tax year 2021, married couples can provide a total gift of $30,000 ($15,000 x 2) to one person. As gifts are made, the unified credit is reduced by the amount of taxes that would have been paid when gifts in excess of the annual gift tax exclusion are made to individuals.
The inheritance tax tables are used to determine the federally-taxable portion of an inheritance. As previously mentioned, they apply to the net estate inherited, not the gross estate or the property's fair market value. Estate taxes are due nine months following the passing of the original property owner. The estate will be settled when a closing letter from the IRS is received confirming the acceptance of the tax forms submitted.
Again, if the estate is large enough to qualify for inheritance tax, the advice of an attorney or accountant specializing in estate taxes should be consulted. Additional information on this topic can be found on the IRS website.
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