Many people believe that the heirs of an estate will be taxed on their inheritance. That is generally not true. Washington does not tax inheritance, and neither does the federal government. Nevertheless, the personal representative is still responsible for managing several important tax issues. For instance, a final personal 1040 return must be filed for the person who has passed away. Also, if the estate has income during the life of the estate, it must file a Form 1041 tax return. Finally, larger estates must file an estate tax return. These larger estates are taxed, but the inheritance that reaches the heirs is not. Each of these tax issues is discussed below. However, the information below is only a general guide to these issues. If you are the personal representative of an estate, you should consult a tax professional as soon as possible, and you should make sure that the person you consult with is familiar with tax issues affecting estates and deceased persons.
The IRS Form 1041 is the income tax return for estates and trusts. If the estate has income during the probate, or if there is any gain on any asset after the date the decedent died, the estate’s income tax return will usually need to be prepared and filed. For example, if the decedent had shares of stock and those shares paid dividends after the person died, but before it was distributed to the heirs, a tax return will usually need to be filed. Another example is if the estate sells a large asset, such as a house, that has gained in value from the date of death to the date of sale. The current filing threshold is $600 of annual income. An experienced tax professional should be able to pass the income tax exposure on to the beneficiaries, however, which will usually result in less overall taxes. This is another reason to start a relationship with a skilled tax professional as soon as possible after you are appointed personal representative.
The easiest tax return to understand is the deceased person’s Form 1040. We all file this return each year if we have enough income to require it. Sadly, death does not extinguish this duty. After death, this responsibility falls to the personal representative. Upon becoming personal representative, you need to review the decedent’s tax filing history (e.g., has the decedent failed to file tax returns in the past) and review any tax statements that come in the mail at the beginning of the year. You will need to ensure that a final personal income tax return is filed, and that any missed filings are rectified.
Estate Tax Return (Form 706)
Although Washington and the federal government impose a tax on larger estates, neither taxes the inheritance once it is received by the heir. This is known as an “inheritance tax,” and some states do impose such a tax, but Washington does not. One note on retirement plans (401ks and traditional IRAs): These are accounts that have income from wages that has never been taxed by the government. Therefore, when a beneficiary inherits this type of account, he or she will be taxed when the money is withdrawn. But this isn’t really an inheritance tax, but just a tax imposed on the beneficiary because the decedent never got a chance to pay the taxes.
If you are managing an estate that requires a Washington or federal estate tax return, you should not be handling the probate yourself. You should be working with an experienced probate attorney and tax professional. You will need to file an estate tax return when the assets of the gross estate meet or exceed the filing threshold for the year the person died. For deaths occurring in 2019, the filing threshold in Washington is $2,193,000. The filing threshold for a federal estate tax return is $11,400,000. Therefore, if the deceased person was a Washington resident and the date of death value of his or her gross estate meets or exceeds $2,193,000, you must file a Washington state estate tax return. It is important to note that in calculating the gross estate, you must include all assets, including land, bank accounts, retirement accounts, annuities, life insurance, and tangible personal property. If the estate value exceeds the filing limit (also known as the exclusion amount), Washington taxes only the amount over the exclusion amount. The tax rate begins at 10% and maxes out out at 20% for estates valued at over $9 million.
Tax Benefit of Inheritance: Step-Up of Cost Basis
A significant tax benefit to inheriting property is called the “step-up” in the cost basis of property. This is how it works: Assume that your mother purchased her house for $100,000 in 1970 and the house is worth $600,000 at the time of her death. If she were to have sold the house during her life, she would owe capital gains tax on the $500,000 of gain (minus her $250,000 home sale tax exclusion, if applicable). The same would be true if she gave the property to you on her death bed: her low $100,000 cost basis would be “carried over” to you. Now assume that instead, you inherit the house after she dies. In that case, you get a full step-up in the cost basis. Your cost basis is now $600,000, wiping out all of that gain. You can turn around and sell the house for $600,000 with no capital gains to realize and pay taxes on. This same rule is true for other assets, such as stock holdings and business interests. This rule provides an interesting benefit to married Washington couples who have community property. Let’s assume that your mother was married and she bought that house with her husband in 1970 and the house is community property. When she dies, the entire value of the house gets a full step up in the cost basis, not just half. The husband’s cost basis in the house is now $600,000 and he can sell it for that price without being exposed to capital gains taxes on the sale. An important lesson of all this is to be very careful when gifting appreciated assets prior to death. Inheriting the property is often best, even if there is some costs related to a probate of the estate.
Obtaining an Estate Tax ID Number (EIN)
There are a few reasons a personal representative will need to obtain a tax identification number for the estate. The most common reasons are to open an estate bank account, complete an income tax return for the estate (Form 1041), and to sell real property. The tax ID number, which is also known as an employee identification number (EIN), can be obtained online through the IRS’s website. The first step is to complete and sign the SS-4 form. Then, apply online for the EIN. In most situations, you will receive the EIN immediately via the on-line process. In some situations, which are usually inscrutable, you cannot get the number online and instead must mail and/or fax the SS-4 form to the IRS and talk to an IRS representative who will then give you the EIN. In most situations, the IRS does not require you to mail in the SS-4 form, but you are expected to maintain the signed document in your records. The IRS has further information about this process on its page for how to apply for an EIN.