Life Events and Taxes
Life is full of milestones. It’s those significant events that we all go through at some point in our lives, like getting married, having a child, buying a home, a divorce, the death of a loved one, etc. Most of these events will affect not only our emotions and finances, but will also have significant tax implications that are often overlooked at the time of the event. This section is devoted to providing tax information related to a variety of life events. It will be a useful guide that covers everything you need to know about the specific event that you are experiencing. It tells you what to expect, things to avoid, the possible consequences of making such a move, and different scenarios that may apply to the situation.
We hope that the information provided in this section will help you cope with any life event that comes your way and encourages you to seek professional assistance when necessary.
Marriage
When a taxpayer becomes married, his or her tax filing status will change. This change in filing status can have significant implications on tax liability, both for the good and bad. A taxpayer’s filing status for the year is determined on the last day of the tax year. Therefore, even if a taxpayer is single for the majority of the year but gets married before the close of the year, he or she must file as a married individual for the entire year. It is not uncommon for tax professionals to recommend waiting until after the close of a tax year to get married. Once a taxpayer is married, he or she must choose between one of the following options:- File a joint return where the couple’s incomes and deductions are combined and all the tax limitations and benefits apply to them jointly, or
- File as married individuals filing separately, which may or may not provide any tax benefit. This may cause a larger combined tax than filing a joint tax return, since the tax code includes penalties to prevent married taxpayers from gaining any tax advantage by filing separately.
Although the tax code is riddled with factors that are related to marriage, the principal ones are summarized below:
- Tax Rates
- Deductions
- Phase-Out IRA Limits
- Social Security Taxation
- Home Sale Issues
- Allocation of Tax Due & Refunds
- Passive Loss Limits
- Education Credits
- Child Care Credits
- Home Mortgage Interest
- Beneficiaries, Title to Property and Wills
- Capital Gains & CG Rates
- Taxation on Dependent Children
Tax Rates – Each filing status has a different tax rate schedule based upon taxable income. As the taxable income increases, so do the tax rates for that marital status. This can create some unexpected results, especially when both taxpayers have income. For example, let’s consider a couple where only one has taxable income; prior to marrying, the filer uses the single status and rates, but once they are wed, lower joint tax rates will be used for the same income and a lower overall tax can be anticipated. On the other hand, if both have income, that income must be combined to determine the couple’s joint tax rate; this can throw them into a higher tax bracket, resulting in a larger tax bite than if they been able to file as single individuals. In addition, the tax rates are determined from taxable income which can be affected by a variety of other factors listed below.
Deductions – Both single and married individuals can choose to use the standard deduction or itemize their deductions. However, once they are married, this option is only available to the couple jointly. Prior to marriage, both could claim the standard deduction or one could claim the standard allowance and the other could itemize, but while married they must choose one or the other. The result can be a significant loss of deductions for the year. This, in turn, can lead to a higher taxable income and thus increased tax. A married couple cannot get around this problem by filing married separate returns, since the tax code requires both to itemize their deductions if either of the couple itemizes.
Some itemized deductions are required to be reduced by a percentage of adjusted gross income. For example, in 2011, only medical expenses in excess of 7.5% of AGI are deductible. Also, there is an overall itemized deduction limitation based on AGI that applies to higher-income taxpayers. Because the joint return of a married couple combines their incomes, the allowed deductions may end up being less than if the couple could file as unmarried individuals. Take for example an individual with AGI of $40,000 and $5,000 of medical expenses. If unmarried, she would include $2,000 of the medical expenses as part of her itemized deduction total ($5,000 - ($40,000 x 7.5%)). If this individual married during the year and her spouse also had income of $40,000 but no medical expenses, they would not be able to deduct any of her medical costs because 7.5% of their combined $80,000 AGI is $6,000, which exceeds the $5,000 of expenses.
IRA Limits – A contribution to a Traditional IRA may not be tax deductible, if the taxpayer or his or her spouse has a retirement plan where they work and their income exceeds a certain amount. Contributions to Roth IRAs may be prohibited altogether depending on income level. Because of these factors, newly married individuals may find that they are no longer eligible to take a deduction for a contribution to a Traditional IRA or contribute to a Roth IRA. This can be especially troublesome for a taxpayer who already made a contribution for the year, based upon their individual income and unmarried status, and then subsequently marries in the same year.
Social Security Benefits Taxation – For lower-income individuals, Social Security (SS) income may be tax-free. However, as a taxpayer’s income increases, the SS income becomes taxable. The threshold for the taxability of the SS income is $25,000 for single individuals and $32,000 for married individuals filing jointly. Combining the incomes of individuals who were previously filing as unmarried and now file jointly generally causes more of the SS income to be taxable. Married individuals who lived together at any time during the year and who file using the married separate status have a zero threshold before their SS income becomes taxable, so there is a major disadvantage to filing separate returns for SS recipients.
Home Sale Issues – A taxpayer who sells his or her main residence after owning and using it as their primary residence for two out of five years prior to the sale qualifies for a $250,000 gain exclusion. Even if the two-out-of-five rule isn’t met, the taxpayer could qualify for a partial gain exclusion. When a couple files a return and they both meet the two-out-of-five-years use requirement, they each qualify for a $250,000 exclusion, thus doubling the excludable amount to $500,000. Where only one spouse owned a home prior to the marriage and would only qualify for a $250,000 exclusion, the couple would qualify for a $500,000 exclusion after marriage once the spouse without a home meets the two-year use requirement.
Where both spouses owned a home before getting married, they can sell either or both of the homes and each benefit from a $250,000 exclusion. There are a number of complications that can be encountered with the complex home sale laws, so be sure to consult with this office prior to taking any home sale actions.
Allocation of Tax Due & Refunds – Married individuals combine their income, deductions, credits, etc., when filing jointly. If there is a refund, it is issued as a single check. Couples who maintain separate funds and accounting will have to determine how to allocate the refund between them. On the other hand, if there is a tax due, the government treats that tax due as a joint liability. If it is not paid, the couple will be pursued both jointly and individually for tax liability.
Where an individual has a tax liability prior to marriage and then files jointly after marriage, the refund from the jointly-filed return can be withheld to pay the spouse’s prior tax liability.
Passive Loss Limits – Where taxpayers have passive losses, most typically from operating rental property, only $25,000 of the losses can be deducted each year (after offsetting any passive income). In addition, the $25,000 maximum loss allowance is phased out for higher-income taxpayers. The phase-out AGI threshold is $100,000 and fully phased out at $150,000. Where both of the taxpayers own rental property, they essentially combine their passive income by getting married. This could cause them to exceed the $25,000 loss limit or increase their income, causing the $25,000 loss limit to be reduced and, in doing so, reduce the amount that can be deducted for the year. On the other hand, if one of them has losses and the other spouse’s passive income is positive, they would be able to offset the one spouse’s passive income with the other’s passive losses. The $25,000 loss allowance is not available to married taxpayers who file separate returns and who lived with their spouse at any time during the tax year.
There are a number of possible scenarios relating to combining passive income and losses that can have a significant impact after marriage. Contact this office to determine the impact based on your particular circumstances.
Education Credits – There are two education credit limitations that can come into play because of marriage:
• The American Opportunity and Lifetime credits are phased out for higher-income taxpayers. Thus, combining incomes on a joint return may cause credits that were allowed as an unmarried individual to be phased out.
• The Lifetime Learning Credit is limited annually to $2,000 per family. Thus, married taxpayers can qualify for only a maximum credit of $2,000, where prior to marriage they could qualify for up to $2,000 each.
Child Care Credits – Where either or both individuals have child or dependent care expenses, getting married can result in some significant changes in the amount of the child care credit.
• Generally, married taxpayers qualify for the credit only if both spouses are employed. There are exceptions for disabled and student spouses. Thus, if only one has care expenses that would have qualified for the credit prior to marriage, those expenses will not qualify when filing jointly.
• The credit, which ranges from 35% to 20% of the care expense, is also reduced for higher-income taxpayers. So by combining incomes on a joint return, it may reduce the credit amount.
• The expenses subject to the child credit are limited to $3,000 for one child and $6,000 for two. Thus, married taxpayers can qualify for only a maximum of $6,000 of expenses, compared to $6,000 for each individual prior to getting married.
Home Mortgage Interest – Generally, home mortgage interest is only deductible on $1 million of home acquisition debt plus $100,000 of home equity debt. Where a couple both owned a home before marriage, they may possibly exceed those limits on their combined homes and, as a result, have a portion of their home mortgage interest deduction disallowed.
Beneficiaries, Title to Property and Wills – Many unmarried individuals will have a parent, sibling, child or other relative designated as the beneficiary for their IRAs, annuities, pension plans and insurance policies. They may also hold title to property in some form of joint ownership with an individual other than their new spouse. These items, and wills and trusts that were drawn up as an unmarried individual, should be reviewed and amended accordingly.
Capital Gains & CG Rates – Capital gains rates are income dependent. Rates are currently 0% and 15% depending on a taxpayer’s taxable income. Thus, a married couple with combined incomes could be subject to a higher capital gains tax than they would have had filing as unmarried. Therefore, consideration for selling capital assets in the year prior to marriage may be appropriate, especially if the one with the potential sale has little other income.
Taxation on Dependent Children – Some years ago, Congress created what is referred to as the “Kiddie Tax” to discourage taxpayers from placing their investment accounts under their child’s name to take advantage of a child’s lower tax bracket. Thus, children are generally taxed on most of their investment income at their parent’s marginal tax rate. A result of combining newlyweds’ incomes on a joint return may be that the tax of a child subject to the Kiddie Tax rules is increased as well.
It may be appropriate to consult with this office before tying the knot to make sure that the tax aspects based on your particular issues are fully understood.
Birth or Adoption of a Child
The birth or adoption of a child is a joyous occasion for the new parents, siblings, grandparents and other family members. A birth or adoption also brings significant life style changes and tax implications for the family. The tax code includes numerous provisions dealing with children:- Tax Exemptions
- Education Savings Plans
- Filing Status
- Child Care Credit
- Child Tax Credit
- Earned Income Credit
- Medical Expenses
- Adoption Credit
Tax Exemption – A taxpayer who files a federal tax return and is not someone else’s dependent is allowed an exemption for themselves, their spouse, and each of their dependents. An exemption reduces a taxpayer’s taxable income for the year, and the inflation adjusted exemption amount for 2011 is $3,700. What an exemption means to a specific taxpayer in terms of tax savings depends upon the individual’s tax bracket. Most taxpayers are in the 15% and 25% brackets. Thus, for example, a taxpayer in the 25% tax bracket would save $925 ($3,700 x 25%) in federal taxes because of the additional exemption. For higher-income taxpayers and those affected by the alternative minimum tax (AMT), the exemption amount may be reduced or not allowed at all.
Children are generally dependents of their parent(s), and the new parent(s) will be able to claim an additional $3,700 (2011) personal exemption for the newborn or adopted child. The full amount of the exemption is allowed regardless of when during the year the child was born (see special rules for adopted children below). In other words, the parent(s) will receive the full exemption (not prorated for the year) whether the child was born on January 1st of the year or December 31st. You may recall those media stories every January 1st about the first child born in your local hospital for the New Year. Although the new parent(s) got all the attention for having the first born in the New Year, they also lost a $3,700 (2011) tax deduction that they would have had if the child had been born on December 31st. The exemption cannot be split between two taxpayers, so if the new parents are unwed, the dependency–and 100% of the tax deduction for the exemption–will generally go to the child’s custodial parent.
Adopted Children – An adopted child is always treated as the taxpayer’s own child. An adopted child includes a child lawfully placed with the taxpayer for legal adoption. Generally, a taxpayer is allowed an exemption for an adopted child, provided the child is both younger than the adoptive parent and is under the age of 19 or a full-time student under the age of 24. There are special rules for foreign adopted children; please call for additional information.
Filing Status – If you are married and have been filing a Joint return, the birth or adoption of a child will not change your filing status. But if you are unmarried and have been filing your tax returns using the Single status, the addition of a child to your household may allow you to use the Head of Household filing status. Eligible Head of Household filers are allowed increased tax benefits. For example, the 2011 federal standard deduction, which is claimed in lieu of itemizing deductions, is $8,500 for Head of Household vs. $5,800 for Single status. Many phase outs of various deductions and credits have higher-income thresholds for Head of Household filers than Single filers, which could result in the Head of Household filer claiming a bigger deduction or credit than a Single filer with the same income. Additionally, the ranges of income are wider for most federal tax rates for Heads of Households than for Singles. For example, a taxpayer with $46,000 of taxable income in 2011 would still be in the 15% tax bracket if filing as Head of Household, but would be in the 25% bracket if filing Single. Thus, the Head of Household filer would pay less tax.
Generally, an unmarried taxpayer can claim the Head of Household status if the taxpayer is a U.S. citizen or resident and pays more than half of the cost of maintaining as his or her home a household which is the main home for more than half the year of a qualifying child, or for a child born during the year, the period during which the child lived in the home. The Head of Household status may also apply when a home is maintained for other qualifying relatives or when certain married individuals who are considered unmarried maintain a household for an eligible child. Please call for details.
Child Tax Credit – Generally, for years through 2011, taxpayers are allowed a tax credit of $1,000 (will drop to $600 after 2013 without Congressional action) for each qualifying child. A qualifying child is one that is under the age of 17 at the end of the year, is not self-supporting, who lived with the taxpayer over half the year and is a U.S. Citizen or national. Children who were born during the year are treated as living with the taxpayer for over half the year even if born in the last half of the year. This credit is generally nonrefundable except for certain low-income taxpayers. Nonrefundable means it can be used to reduce your income tax to zero, but any additional credit is lost. Thus, a qualifying taxpayer with a tax liability of $900 and a child credit of $1,000 would be able to reduce their tax liability to zero, but the $100 excess credit would be lost. The allowable credit does offset the alternative minimum tax (AMT) and the credit is phased out for higher-income taxpayers. The income phase-out threshold for married taxpayers is $110,000 and $75,000 for unmarried taxpayers.
Adopted child - An adopted child is always treated as the taxpayer’s own child. An adopted child includes a child lawfully placed with the taxpayer for legal adoption. In the case of foreign adoptions, if the taxpayer is a U.S. citizen or U.S. national and the adopted child lived with the taxpayer all of the tax year as a member of the taxpayer’s household, that child is treated as being a U.S. citizen, national or resident.
Medical Expenses – The birth of a child is usually accompanied by medical expenses for the care of the mother and the newborn child. Those expenses not reimbursed by insurance or other reimbursement arrangements are added to the taxpayer’s other medical expenses for the year, and deducted as an itemized medical expense to the extent the medical expenses exceed 7½% (10% for those subject to the AMT) of his or her adjusted gross income (AGI).
Where couples are unable to conceive by natural means, some of the artificial methods that have been developed are deductible and some are not. Although not specifically addressed in the tax code or regulations, in vitro fertilization performed on the taxpayer claiming the expense is deductible since the tax code specifically allows procedures that affect the structure or function of the body. IRS has ruled privately that a woman who can't conceive children using her own eggs may claim a medical expense deduction for the costs of obtaining an egg donor, including associated legal costs. The office of IRS Chief Council provided some guidance related to surrogate mother expenses: The tax code allows a taxpayer to deduct the expenses paid during the taxable year, not compensated for by insurance or otherwise, for medical care of the taxpayer, the taxpayer's spouse, or the taxpayer's dependents. A surrogate mother is neither the taxpayer nor the taxpayer's spouse, and typically is not a dependent of the taxpayer. Nor is an unborn child a dependent. Thus, medical expenses paid for a surrogate mother and her unborn child would not qualify as a deduction.
Please call this office for more information related to deductible child birth expenses and future medical expenses of the children.
Education Savings Plans – Along with the newborn or adopted child is the future obligation to educate the child. It is never too soon to start thinking about saving for future educational expenses. The tax code provides two tax-favored plans to save for a child’s education. One is called a Coverdell Education Savings Account and the other is the Sec. 529 Plan (also referred to as a Qualified State Tuition Plan). Neither plan provides for a current tax deduction, but both provide for tax-free earnings when the funds are used for the prescribed education expenses. The three major differences in the plans are the amounts that can be contributed, which education is covered, and who has control of the funds. Contributions to the Coverdell account are limited to $2,000 per year per future student, whereas the contributions to a Sec. 529 plan are only limited by the projected cost of the future education. Coverdell qualified education includes kindergarten through post-secondary education, while Sec. 529 qualified education only includes college (post-secondary) education. Control of the Coverdell Account reverts to the child when the child reaches maturity, while the Sec. 529 plan remains under the control of the contributor. There are other important details relating to each plan, and a consultation appointment is recommended before embarking on a plan.
Child Care Credit – For working parents, the birth or adoption of a child can lead to the need for child care when the parent resumes their employment. A nonrefundable tax credit may be available for the expenses that are incurred for the care of a child (who generally must be under 13 years of age), disabled child, spouse, or other dependent while the taxpayer is gainfully employed (or is job seeking). In addition, employer dependent care assistance programs allow employees to exclude from income certain payments expended for child and dependent care.
Generally, the credit is 20% of the cost of the care with a maximum expense limit of $3,000 for one child and $6,000 for two or more. However, for lower-income taxpayers, the credit percentage can be as high as 35%.
The expenses that are taken into account for the credit are limited to a taxpayer’s earned income (i.e. income from working), and must be reduced by the amount a taxpayer excludes from gross income under an employer-provided dependent care assistance plan. Generally, self-employed taxpayers use the net earnings on Schedule C as earned income.
For taxpayers who file joint returns, the expense is limited to the earned income of the lower paid spouse, so generally both parents must be working or looking for work. Special rules allow a spouse who is disabled or a full-time student to qualify as having earnings when they otherwise have none, thus permitting the couple to claim some credit.
Earned Income Credit - The Earned Income Tax Credit (EIC) provides a refundable tax credit for people who work, but have lower incomes. The credit amount is increased if a family also has children. Qualifying taxpayers may receive a refund even if they have had no income tax withheld. Each year, the credit and income limits are adjusted for inflation. If a taxpayer qualifies, this credit could be worth up to $6,070 for 2011 for a taxpayer with 3 qualifying children. Thus, a qualifying taxpayer will pay less federal tax or could even get a larger refund. While taxpayers without children may qualify for the EIC, the potential amount of the credit is significantly more for eligible taxpayers who have one or more qualifying children. These taxpayers are also allowed to earn over 2½ times more income before the credit is phased out than workers without qualifying children.
The IRS estimates 20 to 25% percent of people who qualify for the credit do not claim it.
Adoption Credit - Adoptive parents may be able to claim a dollar-for-dollar tax credit for the “qualified” expenses of adopting a child – up to $13,360 for 2011 for each adopted child. That is equivalent to a deduction of over $53,440 for a taxpayer in the 25% tax bracket. As part of the Health Care Legislation this credit becomes fully refundable beginning in 2010. Previously the credit was a nonrefundable credit that could not exceed the sum of a taxpayer’s regular and alternative minimum taxes and any unused credit can be carried forward up to 5 years.
In addition, if the employer has an adoption assistance program, a taxpayer may be able to exclude up to $13,360 for 2011 of qualified adoption expenses paid by an employer from his or her gross income. Both the credit and the exclusion can be claimed but not for the same expenses.
The credit is phased out if the taxpayer's income (modified AGI) exceeds a threshold amount and is fully eliminated when AGI reaches the threshold cap. These values are annually adjusted for inflation, and for 2011, the threshold income is $182,520 and the threshold cap is $222,210.
Qualified adoption expenses include reasonable and necessary adoption fees, court costs, attorney fees, traveling expenses (including amounts spent for meals and lodging) while away from home, and other expenses directly related to the legal adoption of an “eligible child.” However, the expenses do not include those to adopt a spouse’s child, surrogate mother expenses, and adoption arrangements that are in violation of state or federal laws. Expenses in connection with an unsuccessful attempt to adopt an eligible child before successfully finalizing the adoption of another child can qualify. Expenses connected with a foreign adoption can only qualify if the child is actually adopted.
An “eligible child” is a child under the age of 18 at the time the qualified adoption expense is paid. If the child turned 18 during the year, the child is an eligible child for the part of the year he or she is under age 18. A person who is physically or mentally incapable of caring for him or herself is also eligible, regardless of age.
There are additional rules related to adopting “special needs” children. Please call this office if you have questions regarding “special needs” adoptions or how the adoption credit will affect your unique circumstances.
Buying Your First Home
It is just about everyone’s dream to own their own home. Buying your first home can seem like an enormous task. There are a great number of issues to deal with. They include the emotional trauma of a lifestyle change, financial aspects, tax implications and legal considerations. The process may seem a bit overwhelming, but everyone has to go through it. There are many books written on the subject and you certainly should approach the process with your eyes wide open and as prepared as possible for the undertaking. The process from start to finish will consume a great deal of your time. The following are some tips to help you down the path to home ownership.• Are You Ready to Buy a Home?
• Home Ownership vs. Renting
• Tax Benefits
• How Much of a Home Can You Afford?
• Location, Size and Amenities
• Selecting a Real Estate Agent
• Creditworthiness
• Shopping for a Loan
• Down Payment
• Holding Title to Your Home
• Maintaining Home Improvement Records
Are You Ready to Buy a Home?
This is the first question that needs to be answered before making a home purchase. There is no need to expend the energy and time it takes to find, finance, acquire, and move into a home if you are not ready. Ask yourself the following questions:
• Do I have a steady source of income (from a job or business)?
• Have I been employed on a regular basis for the last 2-3 years?
• Is my current income reliable?
• Do I have a good record of paying my bills?
• Do I have few outstanding long-term debts like car payments?
• Do I have money available for a down payment?
• Am I credit worthy enough to qualify for home financing?
• Do I have the ability to pay a mortgage every month, plus additional costs?
If you can answer "yes" to these questions, you are probably ready to buy your own home.
Home Ownership vs. Renting
There is a big difference between owning your own home and renting. Generally, renting is free of most home maintenance responsibilities other than cleaning and yard care and even the gardening is included with many rental agreements. But at the end of the rental agreement, you have nothing to show for all those rental dollars that you shelled out, and you are generally at the mercy of the landlord. You have also helped the landlord pay down his mortgage and build his equity instead of yours. That’s not to say home ownership is for everyone; many prefer a lifestyle unencumbered by the responsibilities of home ownership.
On the other hand, a home purchase provides significant benefits, some immediate and some long-term. When you make a mortgage payment, you are building equity. And that's an investment. Owning a home also qualifies you for tax breaks that assist you in dealing with your new financial responsibilities - like insurance, real estate taxes, and upkeep - which can be substantial. But given the freedom, stability, and security of owning your own home, they are generally worth it.
Tax Benefits
The tax benefits available with home ownership can greatly reduce the cost of ownership. An individual who rents cannot deduct the cost of the rent on his or her tax return. However, if you are buying the home, the mortgage interest and property taxes (1) are a tax deduction (when itemizing) which provides considerable benefits and can substantially offset the cost of owning the home. This is best explained by example.
Illustration: Let’s assume that you are a married couple filing jointly. Your mortgage payment is $1,500 per month ($18,000 per year) and the property taxes for the year are $5,000. In the first years after purchasing your home, the mortgage payment is primarily interest, which means most of the payment will be tax-deductible (so we will use $17,000 of the mortgage payment as deductible home mortgage interest). Assume your “other” deductible itemized deductions (medical, charity, other taxes and miscellaneous) for the year after AGI adjustments totaled $4,000 and your standard deduction for the year would have been $11,400. Assuming that you are in the 25% tax bracket, your tax savings can be determined as follows:
Deductible Interest $17,000
Property Taxes (1) 5,000
Other Itemized Deductions 4,000
Total Itemized Deductions 26,000
Standard Deduction (2011) <11,600>
Net Increase in Deductions $14,400
Net Tax Savings (25% Tax Bracket) $3,600
This benefit generally can be more or less based on a number of factors. Had this illustration been for a single taxpayer with a standard deduction of only half that of the joint filing taxpayers, the savings would have been $5,050! Tax bracket also has a big impact. Had the illustration been for a single individual in the 35% tax bracket, the savings would have been $7,070.
You can project your savings by substituting your estimated deductible interest and taxes, using the standard deduction that you would use if not itemizing and your marginal tax rate (2).
(1) Property taxes are deductible by everyone except those subject to the alternative minimum tax (AMT). To the extent you might be subject to the AMT, property taxes will not provide any tax benefit.
(2) Frequently, a taxpayer’s taxable income before and after the increase in deductions will straddle two tax brackets and result in a blended marginal rate.
Keep in mind that the annual cost of the home will be more than mortgage payments and taxes. The lender will require the home to be insured for fire and possibly flood. Your utility bills may increase and an allowance for home maintenance and repairs should be set aside.
Determine How Much of a Home You Can Afford
First of all, you will need enough up-front cash to cover the down payment and closing costs. In addition, unless you are purchasing a furnished model, you will need some amount of cash to cover curtains, paint, and whatever other modifications you think are necessary to occupy the home. Don’t forget that once you buy the house, you will have expenses moving there.
Before you start looking for a home, the following two things should be determined:
What Can You Afford: Before anything else, figure out how much you can comfortably afford for monthly home expenses. That will include the mortgage payment, taxes, insurance, possible increased utilities and an allowance for home maintenance. Formulate a budget that includes all of your other monthly expenses less those expenses attributable to your current rental. Be careful not to overlook transportation, entertainment, medical expenses, eating out, etc., unless you plan to change your lifestyle. Use that budget to determine how much you can afford monthly for housing.
What Loan Amount Will You Qualify For: Unless you have affluent family members, you will need to determine the maximum loan amount that you will qualify for. A potential lender considers your debt-to-income ratio, which is a comparison of your gross (pre-tax) income to housing and non-housing expenses. Non-housing expenses include long-term debts such as car or student loan payments, alimony, or child support. According to the FHA, monthly mortgage payments should be no more than 29% of gross income, while the mortgage payment, combined with non-housing expenses, should total no more than 41% of income. The lender also considers cash available for down payment and closing costs, credit history, etc. when determining your maximum loan amount.
You may wish to get pre-qualified for a mortgage before you make an offer to a seller. Having been previously approved by a mortgage lender removes a large amount of uncertainty in the seller's mind, and increases the likelihood of a quick closing. With pre-qualification, you'll be in a stronger position to negotiate a better price on the house that you would like to buy. Prequalification is quick and easy. Some lenders charge for the service while others don't. It will also let you know ahead of time how large of a loan you are qualified for.
Location, Size and Amenities
Before you start searching for that perfect home, there are several things you need to determine that will save yourself hours of wasted time. Figure out the type of house that you want early in the process and set your requirements. This cuts out a lot of the guesswork and makes it easier for your real estate agent to find something suitable. Things to consider are:
Size: How big of a home do you need? How many bedrooms? Will the family size be increasing?
Amenities: Narrow your search by specifying the amenities that you require, such as the number of bathrooms, a pool, 2 or 3-car garage, fireplace, yard size, etc. Categorize these items by the need, from your minimum requirements to a wish list.
Location: Select a community that you will be comfortable in. Many people choose communities based on the schools. Do you want access to close shopping and public transportation or a more rural area? How close do you want to be to your place of business or family?
Selecting a Real Estate Agent
Typically, the first person you consult about buying a home is a real estate agent or broker. Although real estate brokers provide helpful advice on many aspects of home buying, they may serve the interests of the seller and not your interests as the buyer. The most common practice is for the seller to hire the broker to find someone who will be willing to buy the home on terms and conditions that are acceptable to the seller. Therefore, the real estate broker you are dealing with may also represent the seller. However, you can hire your own real estate broker, known as a buyer’s broker, to represent your interests. Also, in some states, agents and brokers are allowed to represent both the buyer and seller.
Sometimes, the real estate broker will offer to help you obtain a mortgage loan. He or she may also recommend that you deal with a particular lender, title company and attorney or settlement/closing agent. You are not required to follow the real estate broker’s recommendation. You should compare the costs and services offered by other providers with those recommended by the real estate broker. Make sure that you do your research.
Find an agent by inquiring around with associates and friends for recommendations. If you have multiple recommendations, interview them before choosing one. Look for an agent who listens well and fully understands your needs. Pick one who is familiar with the area in which you wish to purchase your home. You want to choose an agent that can provide all the knowledge and services that you need.
Creditworthiness
When you’re applying for credit - whether it’s a credit card, a car loan, a personal loan or a home mortgage - lenders want to know your credit risk level. In other words, “If I give this person a loan or credit card, how likely is it that I will get paid back on time?”
There are three major credit reporting agencies (Equifax, Experian and TransUnion) in the United States that maintain records of your use of credit and other information about you. These records are called credit reports, and lenders will want to check your credit report when you apply for credit. In most cases, lenders will also want to know your credit score. A credit score is a number that summarizes your credit risk, based on a snapshot of your credit report at a particular point in time. A credit score helps lenders evaluate your credit report and estimate your credit risk. Your credit score influences the credit that is available to you and the terms (interest rate, etc.) that the lenders offer you. It’s a vital part of your credit health. If your credit score is low, you will generally end up with a less favorable home mortgage. The interest rate most likely will be higher, which will make the monthly home payments higher.
If you are in the planning stages of acquiring a home, you may wish to check your credit score before applying for a loan. If you find errors in the report, you should take steps to have those errors corrected to improve your score.
The most commonly encountered credit score is your FICO® score, which is easy to check online. Although in most cases, there will be a charge to obtain the FICO® score. An important time to check your FICO® score is six months or so before you plan to purchase a home. This will give you enough time to verify the information on your credit report, correct errors if there are any, and take actions to improve your FICO® score if necessary. In general, any time you are applying for credit, taking out a new loan or changing your credit mix is a good time to check your FICO® score. Improving your FICO score can help you:
• Get better credit offers;
• Lower your interest rates; and
• Speed up credit approvals.
The payoff from a better FICO® score can be big. For example, with a 30-year fixed mortgage of $150,000, you could save approximately $165,000 over the life of the loan - or $459 on each monthly payment - by first improving your FICO® score from 550 to 720.*
* Based on average national interest rates as of September 2007.
Shopping for a Loan
Your choice of lender and type of loan will influence not only your settlement costs, but also the monthly cost of your mortgage loan. There are many different types of lenders and loans you can choose from. You may be familiar with banks, savings associations, mortgage companies and credit unions, many of which provide home mortgage loans. Also check online for a listing of some mortgage lenders or your local newspaper for a listing of rates.
• Mortgage Brokers - Some companies (known as "mortgage brokers") offer to find you a mortgage lender willing to make you a loan. A mortgage broker may operate as an independent business and may not be operating as your "agent" or representative. Your mortgage broker may be paid by the lender, you as the borrower, or both. You may wish to ask about the fees that the mortgage broker will receive for its services
• Government Programs - You may be eligible for a loan insured through the Federal Housing Administration ("FHA") or guaranteed by the Department of Veterans Affairs or similar programs operated by cities or states. These programs may require a smaller down payment. Ask lenders about these programs. You can get more information about these programs from the agencies that run them.
• Computer Loan Origination Systems (CLOs) - CLOs are computer terminals sometimes available in real estate offices or other locations to help you sort through the various types of loans offered by different lenders. The CLO operator may charge a fee for the services the CLO offers. This fee may be paid by you or by the lender that you select.
Types of Loans - Loans can have a fixed or variable interest rate. Fixed rate loans have the same principal and interest payments during the loan term. Variable rate loans can have any one of a number of "indexes" and "margins" which determine how and when the rate and payment amount change. If you apply for a variable rate loan, also known as an adjustable rate mortgage ("ARM"), a disclosure and booklet required by the Truth in Lending Act will further describe the ARM. Most loans can be repaid over a term of 30 years or less and have equal monthly payments. The amounts can change from time to time on an ARM depending on changes in the interest rate. Some loans have short terms and a large final payment called a "balloon." You should shop for the type of home mortgage loan terms that best suit your needs.
Interest Rate, "Points" & Other Fees - The price of a home mortgage loan is usually stated in terms of an interest rate, points and other fees. A "point" is a fee that equals 1 percent of the loan amount. Points are usually paid to the lender, mortgage broker, or both, at the settlement or upon the completion of the escrow. Often, you can pay fewer points in exchange for a higher interest rate or more points for a lower rate. Ask your lender or mortgage broker about points and other fees.
A document called the Truth in Lending Disclosure Statement will show you the "Annual Percentage Rate" ("APR") and other payment information for the loan you have applied for. The APR takes into account not only the interest rate, but also the points, mortgage broker fees and certain other fees that have to be paid. Ask for the APR before you apply to help you shop for the loan that is best for you. Also ask if your loan will have a charge or a fee for paying all or part of the loan before the payment is due, otherwise known as the prepayment penalty. You may be able to negotiate the terms of the prepayment penalty.
Lender-Required Settlement Costs - Your lender may require you to obtain certain settlement services, such as a new survey, mortgage insurance or title insurance. They may also order and charge you for other settlement-related services, such as the appraisal or credit report. A lender may also charge other fees, such as fees for loan processing, document preparation, underwriting, flood certification or an application fee. You may wish to ask for an estimate of fees and settlement costs before choosing a lender. Some lenders offer "no cost" or "no point" loans but normally cover these fees or costs by charging a higher interest rate.
Comparing Loan Costs - Comparing APRs may be an effective way to shop for a loan. However, you must compare similar loan products for the same loan amount. For example, compare two 30-year fixed rate loans for $100,000. Loan A with an APR of 5.35% is less costly than Loan B with an APR of 5.65% over the loan term. However, before you decide on a loan, consider the up-front cash you will be required to pay for each of the two loans as well.
Another effective shopping technique is to compare identical loans with different up-front points and other fees. For example, if you are offered two 30-year fixed rate loans for $100,000 and at 8%, the monthly payments are the same, but the up-front costs are different:
Loan A - 2 points ($2,000) and lender required costs of $1,800 = $3,800 in costs.
Loan B - 2 1/4 points ($2,250) and lender required costs of $1,200 = $3,450 in costs.
A comparison of the up-front costs shows Loan B requires $350 less in up-front cash than Loan A. However, your individual situation (how long you plan to stay in your house) and your tax situation (points can usually be deducted for the tax year that you purchase a house) may affect your choice of loans.
Lock-ins - "Locking in" your rate or points at the time of application or during the processing of your loan will keep the rate and/or points from changing until settlement or closing of the escrow process. Ask your lender if there is a fee to lock-in the rate and whether the fee reduces the amount you have to pay for points. Find out how long the lock-in is good, what happens if it expires, and whether the lock-in fee is refundable if your application is rejected.
Tax and Insurance Payments - Your monthly mortgage payment will be used to repay the money you borrowed plus interest. Part of your monthly payment may be deposited into an "escrow account" (also known as a "reserve" or "impound" account) so your lender or servicer can pay your real estate taxes, property insurance, mortgage insurance and/or flood insurance. Ask your lender or mortgage broker if you will be required to set up an escrow or impound account for taxes and insurance payments.
Transfer of Your Loan - While you may start the loan process with a lender or mortgage broker, you could find that after settlement another company may be collecting the payments on your loan. Collecting loan payments is often known as "servicing" the loan. Your lender or broker will disclose whether it expects to service your loan or to transfer the servicing to someone else.
Mortgage Insurance - Private mortgage insurance (PMI) and government mortgage insurance protects the lender against default and enables the lender to make a loan which is considered a higher risk. Lenders often require mortgage insurance for loans where the down payment is less than 20% of the sales price. You may be billed monthly, annually, by an initial lump sum, or some combination of these practices for your mortgage insurance premium. Ask your lender if mortgage insurance is required and how much it will cost. Mortgage insurance should not be confused with mortgage life, credit life or disability insurance, which is designed to pay off a mortgage in the event of the borrower's death or disability.
You may also be offered "lender paid" mortgage insurance ("LPMI"). Under LPMI plans, the lender purchases the mortgage insurance and pays the premiums to the insurer. The lender will increase your interest rate to pay for the premiums - but LPMI may reduce your settlement costs. You cannot cancel LPMI or government mortgage insurance during the life of your loan. However, it may be possible to cancel private mortgage insurance at some point, such as when your loan balance is reduced to a certain amount. Before you commit to paying for mortgage insurance, find out the specific requirements for cancellation.
Flood Hazard Areas - Most lenders will not lend you money to buy a home in a flood hazard area unless you pay for flood insurance. Some government loan programs will not allow you to purchase a home that is located in a flood hazard area. Your lender may charge you a fee to check for flood hazards. You should be notified if flood insurance is required. If a change in flood insurance maps brings your home within a flood hazard area after your loan is made, your lender or servicer may require you to buy flood insurance at that time.
Down Payment
If you have the funds for a down payment and a good credit rating, this is probably a good time to purchase a home, since there is a large inventory of property available and the prices are lower than they have been for a number of years.
The typical down payment required for the purchase of a home is twenty percent of the purchase price. In the past, banking on steadily increasing home values, some creative financing arrangements required a much smaller down (some no down payment at all). However, with the decline in home values during 2008, these creative home loan arrangements are generally no longer available.
If you lack the ready cash for the down payment or are short on the amount you need, the following may be possible sources:
IRA Account - If you have an IRA account and you qualify as a first-time home buyer, tax law permits you to make up to a $10,000 penalty-free withdrawal from an IRA to purchase a home. (Please note that even though the withdrawal might be penalty-free, it is still taxable). The tax definition of a first-time homebuyer is quite different from the literal definition of a first-time homebuyer. As it turns out, you can qualify even if you owned a home before. Generally, you are a first-time homebuyer if you had no present interest in a main home during the 2-year period ending on the date of acquisition of the home which the distribution is being used to buy, build, or rebuild. If you are married, your spouse must also meet this no-ownership requirement. To qualify for the first-time homebuyer penalty exception, the distribution must be used to pay qualified acquisition costs before the close of the 120th day after the distribution was received. When added to all of the taxpayer's prior qualified first-time homebuyer distributions, if any, the total distributions cannot be more than $10,000. If the taxpayer is married, both can withdraw up to $10,000.
Other Retirement Accounts – The penalty-free withdrawal from IRA accounts does not apply to other types of retirement accounts. However, funds can be rolled from a qualified plan to an IRA and then a penalty-free distribution can be taken from the IRA.
Gifts – Often parents or other relatives can assist a potential homebuyer by gifting them the funds to help with the down payment.
Holding Title to Your Home
You also need to consider how you intend to hold title to the home. Surprisingly, many home purchasers don't give much attention to the question even though the manner in which the title is held can have far-reaching ramifications.
The best way to come to a decision about the title is to consult with a real estate attorney. Before you do that, however, you may want a little background on the more prevalent title-holding methods:
• Title held in the name of one individual. Single individuals would probably be the most likely candidates for this method of holding title. However, married individuals may also, for one reason or another, choose to take title individually rather than with their spouse. When the owner of the property dies, probate is necessary. However, the property takes on a new value for the beneficiary - generally equal to its fair market value at the date of the original owner's death.
• Joint tenancy with right of survivorship. Under this form of ownership, all (two or more) owners hold title to the property. Each owns an equal share of the property. When one owner dies, the others become owners of the decedent's portion. An advantage of joint tenancy is that it cuts probate costs since the decedent's portion of the property normally reverts to the remaining joint tenants automatically (ownership recording, of course, need to be changed). The basis of the decedent's part is revalued at the date of death.
• Community property. Married couples in community property states of Arizona, California, Idaho, Nevada, New Mexico, Louisiana, Texas, Washington and Wisconsin can claim community title to property. Under community property rules, each spouse owns half of the property and each spouse can pass his/her portion either to the other spouse or to someone else. An advantage of community property is that when it is willed to a surviving spouse, the entire property gets revalued to its fair market value at the date of the decedent spouse's death.
Other methods of holding title, like tenancy in common or holding property in trust, are also available. All have their "special" pros and cons. Some community property states also have special methods of holding title such as California’s “community property with right of survivorship,” which combines the tax benefits of holding title as community property including a double basis adjustment with the ease of property transfer available to the survivor of joint tenancy property. Before making your final decision, take some time to check out the different methods of holding title in your state to determine what’s best for you.
Maintaining Home Cost & Improvement Records
One of the benefits of home ownership is the ability to exclude up to $250,000 ($500,000 for a married couple) of gain from the sale of the home. To qualify for the exclusion, taxpayers must meet the ownership and use tests. This means that during the 5-year period ending on the date of the sale, taxpayers must have:
1) Owned the home for at least 2 years (if a joint return, only one spouse needs to meet the ownership test), and
2) Except for short temporary absences, lived in (used) the home as their main home for at least 2 years.
The required 2 years of ownership and use during the 5-year period ending on the date of the sale does not have to be continuous. Taxpayers meet the tests if they can show that they owned and lived in the property as their main home for either 24 full months or 730 days during the 5-year period ending on the date of sale. Where taxpayers do not meet the two-out-of-five use and ownership requirements, they may qualify for a reduced exclusion if the home was sold as a result of unforeseen circumstances.
Maintaining good records will help reduce any future gain and minimize any potential tax when the home is sold. Therefore, it is important to keep a copy of your purchase documents that itemize the costs of purchasing the property, along with substantiation for all subsequent improvements to the home. Don’t make the mistake of thinking that the $250,000 or $500,000 gain exclusion will cover all subsequent appreciation in value of the home.
Death of a Loved One
The death of a loved one is one of life’s most difficult times and a time for reflection and grieving. However, it also triggers unique financial and tax events that must be dealt with by the survivors. For a surviving spouse, this is an especially difficult time and can be devastating if the death was sudden with little or no time to make financial preparations.This material is divided into several sections dealing with the various aspects of a passing and provides information to help you work through the various financial problems and details that must be attended to with the death of a loved one.
• Collecting Paperwork
• Social Security
• Probate Decedent’s
• Final Tax Return
• Other Tax Returns
• Surviving Spouse
• Surviving Spouse Filing Status
Collecting Paperwork – Gathering the proper paperwork is the first step in settling a decedent’s affairs. These documents will be necessary to file and collect benefits, file taxes, etc. This task is generally the responsibility of the decedent’s surviving spouse or, if unmarried, whoever is responsible for the decedent’s affairs.
Death Certificate - The death certificate will be needed for many financial procedures that will be encountered. Request several copies (ten is recommended in most cases). These are usually available from the funeral director. If not, they will be available from the county health department.
Decedent’s Insurance Policies - These will help you determine the benefits entitled to by the survivors. In addition to looking for life insurance policies, don’t overlook veteran’s policies, mortgage insurance policies and death benefits associated with car loans, credit cards, installment accounts, health policies, employer plans and retirement plans.
Surviving Spouse’s Insurance Policies - If the decedent is the beneficiary of the spouse’s policies, the surviving spouse may wish to file change of beneficiary notices with the insurance carrier.
Marriage Certificate - A surviving spouse will sometimes need to provide proof of the marital relationship to apply for certain benefits. If you are unable to find one, a copy can usually be obtained from the county offices of the place where the couple was married.
Birth Certificates - For dependent children birth certificates may also be needed when applying for certain benefits. If copies cannot be found, one can be obtained from the county or state in which a child was born.
Certificate of Discharge from the Military - If your spouse was in the military, you may need his or her certificate of discharge to collect certain benefits. If discharge or separation documents are lost, veterans or the next of kin of deceased veterans may obtain duplicate copies by completing forms found on the Internet at http://www.archives.gov/research/index.html and mailing or faxing them to the NPRC. Alternatively, write the National Personnel Records Center, Military Personnel Records, 9700 Page Ave., St. Louis, MO 63132-5100. It is not necessary to request a duplicate copy of a veteran’s discharge or separation papers solely for the purpose of filing a claim for VA benefits. If complete information about the veteran’s service is furnished on the application, the VA will obtain verification of service.
The Deceased's Will or Trust Documents - The decedent may have had a will or trust. A copy of the will or trust will be required. The decedent’s attorney will have copies of these documents.
Decedent’s IRA and Pension Plans - Compile a list of the decedent’s IRA accounts and pension plans and determine who the beneficiary or beneficiaries are for each.
Spouse’s IRA and Pension Plans - If the decedent is the beneficiary of the spouse’s IRA or pension plans, the surviving spouse may wish to file change of beneficiary notices with the plans.
Complete List of All Property - Generally, the assets of all decedents will go through state probate, estate, or trust proceedings and a complete inventory of the decedent’s assets will be needed. The date-of-death value of each of the assets owned by the decedent will need to be determined for the probate or trust administration. For some assets, such as real estate, a professional appraiser may need to be hired to determine the amount. In most cases it is advisable for the surviving spouse, executor and/or trustee to meet with an attorney, as well as their tax and financial advisors, who will guide them through this process.
Frequently, taxpayers maintain their most important documents in a safe deposit box. Where possible, the contents should be removed before the decedent’s passing. Depending upon the jurisdiction, sometimes the boxes are sealed upon the owner’s or joint owner’s death. If the box is sealed, it will require a court order to gain access to the box.
Social Security – The Social Security Administration (SSA) should be notified as soon as possible when a person dies. In most cases, the funeral director will report the person's death to the SSA. The funeral director has to be furnished with the deceased's Social Security number so that he or she can make the report.
Some of the deceased's family members may be able to receive Social Security benefits if the deceased person worked long enough under Social Security to qualify for benefits. Get in touch with the SSA as soon as possible to make sure the family receives all of the benefits to which they may be entitled. The following is information on the benefits that may be available.
• A one-time payment of $255 can be paid to the surviving spouse if he or she was living with the deceased; or, if living apart, was receiving certain Social Security benefits on the deceased's record. If there is no surviving spouse, the payment is made to a child who is eligible for benefits on the deceased's record in the month of death.
• Certain family members may be eligible to receive monthly benefits, including:
o A widow or widower age 60 or older (age 50 or older if disabled);
o A surviving spouse at any age who is caring for the deceased's child under age 16 or disabled;
o An unmarried child of the deceased who is:
- Younger than age 18 (or age 18 or 19 if he or she is a full-time student in an elementary or secondary school); or
- Age 18 or older with a disability that began before age 22;
o Parents, age 62 or older, who were dependent on the deceased for at least half of their support; and
o A surviving divorced spouse, under certain circumstances.
If the deceased was receiving Social Security benefits, the benefit received for the month of death or any later months must be returned. For example, if the person dies in July, the benefit paid in August must be returned. If benefits were paid by direct deposit, contact the bank or other financial institution. Request that any funds received for the month of death or later be returned to the Social Security Administration. If the benefits were paid by check, do not cash checks received for the month in which the person dies or later. Return the checks to the SSA as soon as possible.
Probate – This is the legal process of settling the estate of a deceased person, specifically resolving all claims and distributing the deceased person's remaining property per the decedent’s wishes under a valid will. This process is generally handled by a probate court which protects the wishes of the deceased, confirms the executor (usually named in the will) as the personal representative of the estate, protects the interests of family members who may have claims against the estate, and protects the executor against claims and lawsuits. If there is no will, the court will appoint a personal representative, usually the decedent’s spouse if married at the time of death. In general, the probate process normally entails the following:
• In most cases, the survivors will engage an attorney to handle the probate and petition the court to begin the probate proceedings.
• The cost of probate is generally based on the value of the decedent’s assets and is usually set by law.
• The court will appoint a personal representative.
• Notices will be published informing creditors, heirs and beneficiaries of the probate proceedings, allowing them ample time to make claims.
• The assets will be appraised.
• The creditors will be paid.
• The remaining assets will be distributed to the heirs and beneficiaries.
Note: Assets held in a living trust are not required to be probated and skip the probate process; this saves the beneficiaries both time and money. Also, assets that are jointly owned by the deceased and someone else are not subject to probate. IRA accounts with a named beneficiary and the proceeds from life insurance policies are also not subject to probate.
Decedent’s Final Tax Return - Upon the death of a taxpayer, a personal representative (e.g., estate executor/executrix) takes charge of the decedent’s property. This person may be named in the decedent’s will or trust document, or appointed by the court if there is no will or trust. When the taxpayer is married, that person is generally the surviving spouse. The duties of the representative include collecting all of the decedent’s property, paying creditors, and distributing assets to the heirs. In addition, the representative is responsible for filing various tax returns and seeing that the taxes owed are properly paid. The decedent’s final income tax return is filed on a 1040 series return.
Filing Requirements - The requirements for filing a return for a deceased taxpayer are generally the same as if the taxpayer were still living--based on income level, age and filing status.
Due Date – The due date for a decedent’s final return is the same as for any other individual (Generally April 15 of the following year, but extendable to October 15. Note: if either April 15 or October 15 fall on a Saturday, Sunday or Holiday the due date in the next business day.
Filing Status - Generally, if the taxpayer was married at the time of death, the decedent will file a joint return with the surviving spouse; otherwise, he or she will file as an unmarried individual. However, taxpayers who were married at the time of death may not file a joint return with the surviving spouse, where the spouse refuses to file jointly, the surviving spouse has remarried, or the executor of the estate does not agree to the joint filing status.
Refunds - If a decedent’s return claims a refund, Form 1310, Statement of Person Claiming Refund Due a Deceased Taxpayer, should be filed. However, Form 1310 is not needed if the person claiming the refund is the surviving spouse of the decedent, filing a joint return with the decedent, or a court-appointed or certified personal representative is filing an original return for the decedent.
Income to Include - Generally, the decedent’s income on the final return only includes income derived up to the date of death. Post-death income is taxable to the decedent’s estate or trust, but the estate or trust will generally pass the taxable income on to the beneficiaries for inclusion in their individual returns if the income has actually been distributed to the beneficiaries during the same reporting period.
Tax Attributes - Tax attributes are exemptions, deductions and carryover items. Where a decedent was married, the attributes must be allocated to the decedent and the surviving spouse based on ownership and state property laws. For example, a married couple has a capital loss carryover of $10,000. Assuming the losses came from jointly-owned property, one-half of the capital loss carryover would belong to the decedent and half to the surviving spouse, allowing the surviving spouse to continue to carry over his or her share. The decedent’s share of the carryover can only be used on the final return and any leftover is lost. The following is the treatment of some of the more common tax attributes:
• Carryovers – Generally, except as noted below, carryover deductions and credits can be used to the extent normally permitted on the decedent’s final return, but any excess does not carry over to the estate or beneficiaries. The carryovers included in this category are net operating loss (NOL), investment interest deduction, capital loss, business credit, minimum tax credit, passive loss credit, and the charitable contribution deduction.
• Medical Expenses - Medical expenses paid before death are claimed on the decedent’s final return as an itemized deduction in the usual manner. Medical expenses not deductible on the final return become liabilities of the estate, and they are deducted on the estate tax return (Form 706), if one is required to be filed. However, expenses that were paid out of estate funds within one year after death can be, at the discretion of the executor, treated as if paid by the decedent and claimed on the decedent’s final return instead. To make the election, file a statement with the decedent’s final return that the expenses are not being claimed on the estate tax return.
• Charitable Contributions - As noted previously, charitable contribution carryovers are lost if not used on the final return. The fair market value of property of an individual that is donated to charity after the individual’s death may be claimed as a charitable contribution by the beneficiary who was designated to inherit the property.
• Domestic Production Deduction - Where the decedent performed qualifying Section 199 production activities with respect to property transferred to a successor in interest, the successor in interest is treated as having performed the qualifying Section 199 production activities. Thus, if the successor in interest satisfies other relevant requirements, the successor in interest will be entitled to a domestic production activities deduction with respect to the transferred property.
• Foreign Tax Credit Carryovers - Foreign tax credit carryovers can be used by the taxpayer's estate or heirs.
• Passive Losses - When a passive interest is transferred due to death, the accumulated suspended losses from the activity are deductible on the decedent’s final return. The deduction amount is limited to the excess of the basis of the property in the hands of the transferee (heir) over the decedent’s adjusted basis in the property just before death. In other words, the amount of the passive activity loss that equals the step-up in basis due to the decedent's death is not allowed as a deduction to anyone in any tax year.
Example: Robert was the sole owner of a residence used as a rental, a passive activity, when he died. In his will, he left the property to his brother Tom. At Robert’s date of death, the value of the rental was $500,000, his adjusted basis was $494,000, and he had unused passive activity losses of $8,000. Since Tom’s basis of the rental is increased by $6,000, the deduction on Robert’s final return for the year of death would be limited to $2,000 ($8,000 - $6,000). If the inherited basis had been $502,000 or more, none of the suspended passive loss would have been deductible ($502,000 – 494,000 = $8,000; $8,000 - $8,000 = $0).
• Exemptions - The full value of the decedent’s exemption is claimed on the final return; proration based on the time the taxpayer was alive for the final year is not required.
• Unrecovered Investment in Pensions - If a retired person dies before recovering the entire basis in a pension or annuity (that started after 1986), the unrecovered portion is allowed as a deduction on the retiree’s final return. If the annuity is for the joint lives of a retiree and a designated beneficiary, the deduction would apply to the final return of the last to die. Otherwise, it would be allowed on the final return of the retiree decedent.
• Funeral Expenses - Are NOT deductible on the decedent’s or survivor’s income tax returns. If an estate tax return is required to be filed, funeral expenses are an allowed deduction on it.
Other Tax Returns – In addition to the decedent’s final return, there are other returns that may need to be filed, along with taxes paid. All income of the decedent both before death and after death is taxable. Since the decedent’s final return only includes income up to the date of death, the income after death, such as income from investments and businesses, is included on a “fiduciary” income tax return (Form 1041 for federal and an equivalent state return). Whether the tax on this income is paid by the estate (or trust) or the beneficiary depends on whether the income is retained by the estate or trust or passed on to the beneficiary during the applicable tax period. It is not unusual for a Form 1041 to have to be filed for more than one tax year (or partial year), as settling an estate or trust often can take over a year.
Estate Tax - Congress has reinstated the estate tax through 2012. For 2011, the Federal estate tax exemption is $5 million and a top tax rate of 35%. Form 706 must be filed if the estate value exceeds the $5 million exemption.
State laws vary, but generally any estate which pays a federal estate tax must also file a state estate or death tax form and pay the state death tax. Most states do not impose an inheritance tax. Consult this office for further information.
Surviving Spouse – Getting one’s financial issues in order after the passing of a spouse can be a difficult and emotional time. Hopefully, you and your deceased spouse had preplanned for this eventuality. If your spouse managed your financial affairs, taking over these affairs and those associated with his or her passing can seem overwhelming. A surviving spouse will need to carefully assess his or her financial situation. If the breadwinner passed away, his or her earned income will probably go away too. If the opposite is the case and there are children, the surviving spouse will need to make arrangements so that he or she can continue working. If the couple was retired, will the retirement income be lost or reduced? Unless you have significant financial resources, these issues need to be addressed rather quickly. However, avoid any immediate long-term decisions; they will probably be emotionally based.
Survivor Benefits – One of the first steps should be assessing what benefits you qualify for and then applying for those benefits.
• Insurance – Hopefully, you have a list of policies issued to your spouse. If not, contact those companies that might have a policy on your deceased spouse. Inquire at your insurance agency and look in the safe deposit box. In addition to your life insurance policies, don’t overlook the following:
o Veteran’s life insurance coverage
o Installment accounts with life insurance coverage
o Mortgages with life insurance coverage
o Employer group term policies
o Credit card accounts with life insurance coverage
o Car loans with life insurance coverage
o Health insurance policies
o Retirement plans with death benefits
o Annuities
Note: Be aware of all possible settlement options. Insurers may offer various settlement terms, such as a lump sum payment or annuitized payments (fixed amounts) over a period of years. Carefully consider your circumstances before deciding. A lump sum can help pay off immediate financial needs, but a payment plan can provide long-term income security. Consult with your financial advisor before making a decision.
• Social Security – You may qualify for Social Security benefits.
• Veteran’s Benefits – If your spouse was a veteran, you may be eligible for one or more of the benefits provided by the U.S. Department of Veterans Affairs. These include assistance with burial, plot and grave markers. The funeral home may be able to help you apply for these benefits. If your spouse was receiving veteran’s disability benefits, you and your dependent children may also be entitled to continued payments. Contact your area’s VA office for assistance.
• Employee Benefits – If your deceased spouse was already retired and receiving pension payments from past employers, you will need to contact those employers to see if the pension will continue to pay the full or a reduced monthly amount or whether it will cease paying benefits upon your spouse’s passing. Some employer pension plans also provide a small death benefit. Most employer pension plans, at the time of initial retirement, offer a choice for the retirement plan to pay only over the life of the retiree or a reduced amount over the joint lives of the retiree and spouse. Hopefully, you and your spouse chose the latter.
If your deceased spouse was still working at the time of death, there are a number of things you should check into, such as:
- Does the employer provide survivor benefits?
- Are there 401(k) or similar type retirement savings plans that you are entitled to?
- Are you entitled to accrued vacation and sick leave payments?
- Was the deceased covered under any life insurance policy provided by the employer?
- Was your spouse a member of a union or professional association that might provide death benefits?
- If the death was work-related, are you entitled to worker’s compensation benefits?
Creating A Budget – Depending upon your overall financial situation, it may be appropriate for you to develop a budget based on your new financial circumstances. This is especially important if your income has been reduced. The sooner you have your finances in order, the better. Estimate your income first; include your wages if working, Social Security and retirement benefits, investment income and other sources.
Next, list your expenses. These include housing, food, utilities, taxes, medical care and insurance, entertainment, clothing, transportation, insurance, school expenses for your children, etc. Be sure to set aside an amount that can be added to reserves for unexpected expenses, such as a broken water heater, car repair, etc. Also, if you are not already retired, be sure to set aside amounts to fund your future retirement as well.
Now compare your income with your expenses. If your expenses exceed your income, you will need to reduce spending. If the income exceeds your expenses, you can save the difference. Be conservative for the first year or so while you fine-tune your budget.
Change Designations - You will want to begin the process of removing your deceased spouse from title to property, credit accounts, vehicle registrations, bank accounts, investment accounts, etc. Also review your beneficiary designations on your own life insurance, IRA accounts and will to ensure who inherits them from you. You may also need or wish to change the executor designation in your own will.
Surviving Spouse Filing Status – Generally, an individual’s filing status is predicated on their marital status at the end of the tax year. However, there are special rules related to the spouse of a deceased taxpayer. In the year of death, a surviving spouse is no longer considered married for tax purposes but can still file jointly with the deceased spouse if the executor of the decedent’s estate agrees. Generally, the surviving spouse will file jointly with the deceased spouse. If not, and if the surviving spouse has not remarried, then he or she would file as a married taxpayer separately or as head of household if he or she qualifies. If the surviving spouse has remarried, then he or she would file either married joint with the new spouse or married separate.
Subsequent Years – In the years following the death of a spouse and assuming the surviving spouse has not remarried, he or she would file as follows:
• Qualified Widow(er) – If the surviving spouse has a dependent child living at home, the surviving spouse can file as a qualified widow or widower. This favorable filing status is essentially the same as filing a joint return, except that there is no deduction for the deceased spouse’s exemption. The widow or widower can use this status for a period of two years as long as he or she meets the requirements for the filing status.
• Head of Household – If the surviving spouse can no longer qualify for the qualified widow(er) status, and he or she provides over half the household expenses for a qualified child or dependent, he or she may qualify for the Head of Household rates, which are not as beneficial as a qualified widow(er) but are significantly better than filing as a single individual.
• Single – If the surviving spouse does not qualify for one of the filing statuses described above, then he or she would be required to file as a single individual.
Widows and widowers should be aware that all of the foregoing filing statuses will provide less exemption deductions and, in the case of the head of household and single filing status, higher marginal tax rates and reduced standard deductions may result. This could, without proper planning, lead to unpleasant taxes due or a significantly reduced refund when the return is filed.
Divorce Issues
Divorce can be one of life’s most traumatic events and is seldom amicable. A couple must divide up their assets and establish separate households which, except for the wealthy, will bring about financial hardship and stress. Added to this financial burden are the legal costs and, where children are involved, custody and visitation issues. Not to be overlooked are the long-term financial issues of alimony and child support. Substantial tax laws have evolved to deal with these issues and are detailed below.• Attorney Fees & Court Costs
• Property Settlements
• Children
• Primary Residence
• Filing Status
• Alimony
Attorney Fees & Court Costs – The general rule for legal expenses (including attorney fees, court costs, etc.) is that they are tax deductible if incurred in the production or collection of taxable income and there must be a reasonably close connection between the legal expense and the production or collection of taxable income.
Thus, the legal costs connected with divorce, separation or support is considered nondeductible personal expenses.
Nondeductibility extends to legal fees incurred in disputes over money claims. The part of legal fees attributable to producing taxable alimony is deductible by the recipient of the alimony. The attorney should stipulate what part of the fee relates to alimony to ensure a deduction for the alimony recipient.
When related to the production of taxable alimony, the legal fees are deducted as a miscellaneous itemized deduction subject to the 2% of adjusted gross income (AGI) limits, which means the taxpayer deducting the expense must itemize his or her deductions and can only deduct the amount of total miscellaneous expenses that exceeds 2% of his or her income (AGI).
Children – The tax code provides a number of tax benefits related to children. When couples with children become divorced, the tax code specifies who benefits from those tax advantages.
Child Support - The financial responsibility to support their children lies with divorced parents in the same manner as when the child’s parents were married. Thus, if one parent is required to make child support payments to the other parent, those payments are not deductible by the parent making the payments, nor are they taxable to the parent receiving the payments.
Tax Exemption – Each qualified child (generally those under the age of 19 or full-time students under the age of 24) represents a tax deduction in the form of a personal exemption to the parent with custody of the child. The exemption amount for 2011 is $3,700 and, for example, creates a tax savings of $555 ($3,700 x .15) for taxpayers in the 15% tax bracket.
Custodial Parent – Often, divorcing parents will be awarded joint custody. However, tax law generally does not allow the tax benefits to be shared by both parents instead allowing only one parent to qualify for the benefits; that parent is the one with physical custody more than 50% of the year. For years, this was a difficult area with some parents who were literally clocking the amount of time day and night the child was with them in order to claim the exemption for the year.
This, in many cases, got so far out of hand that the IRS recently adopted new regulations to deal with the issue. The IRS now defines a “custodial parent” to be the parent with whom the child resides for the greater number of nights during the year. A child resides with a parent for a night if the child sleeps at the residence of that parent (whether or not the parent is present) or in the company of the parent when the child doesn’t sleep at the parent’s residence, such as when the parent and child are on vacation together. The time that the child goes to sleep is irrelevant. Provisions for special circumstances include:
• Absences of Child - If a child is temporarily absent from a parent’s home for a night, the child is treated as residing with the parent with whom the child would have resided for the night. A night is not counted for either parent if the child would not have resided with either parent for the night (for example, because a court awarded custody of the child to a third party for the period of absence) or it cannot be determined with which parent the child would have resided for the night.
• Equal Number of Nights - If a child resides with each parent for the same number of nights, then the parent with the higher AGI for the year is treated as the custodial parent.
• Night Spans Two Years – A night that extends over two tax years is allocated to the tax year in which the night begins. Thus, for example, a night that begins on December 31, 2010 is counted for taxable year 2010.
• Parent Works at Night – If, due to a parent’s nighttime work schedule, a child resides for a great number of days but not nights with the parent who works at night, that parent is treated as the custodial parent. On a school day, the child is treated as residing at the primary residence registered with the school.
Divorce Agreements & Decrees Don’t Trump Federal Tax Law – It is not uncommon for divorce attorneys, and sometimes the divorce courts, to specify in the divorce agreement or decree who is to claim a child’s exemption. It is important to understand that “exemption” is part of Federal tax law, and a divorce proceeding cannot trump Federal tax laws. Thus, regardless of what the divorce agreement reads, the exemption can only be claimed by the parent with custody the greater part of the year unless the custodial parent releases (in writing) the exemption to the other parent. The release can be for a single or multiple years and a custodial parent should exercise caution in executing a release, especially for more than one year. The release must be a written declaration and it must be unconditional (no strings attached such as requiring the non-custodial parent to meet support payment obligations). It must name the non-custodial parent and specify the year or years for which it is effective. If it specifies “all future years,” it is treated as specifying the first taxable year after the year in which it is executed and all subsequent years.
If the release is not made on the official IRS form, it must conform to the substance of that form, and it must be executed for the sole purpose of serving as a written declaration under this section. A court order or decree or separation agreement may not serve as a written declaration (because it has other purposes than releasing the exemption to the non-custodial parent). The IRS also will not accept a state court’s allocation of exemptions because the Internal Revenue Code, not state law, determines who may claim a child’s exemption for federal income tax purposes.
The non-custodial parent must attach a copy of the written declaration to his or her return for each year in which the child is claimed as a dependent.
Last to File – Occasionally, both parents will attempt to claim the same child. This will not go unnoticed by the IRS, since they match tax ID numbers and will always discover when both parents have claimed the same child and issue a notice of tax change to the parent that filed last. Although not necessarily fair, the IRS will deny the child’s exemption for the parent who filed last and require that parent to prove entitlement to the exemption before reversing their decision.
Effect on Filing Status – For income tax purposes, a taxpayer’s marital status for the entire year is determined on the last day of the tax year. Thus, unless remarried, a divorced couple will be treated as unmarried individuals beginning in the year their divorce is final. Where there are no children or other qualified dependents, this means that starting with the year the divorce is final, the former spouses will each file a return using the “Single” status. However, if the couple has a child or children, the custodial parent, if not remarried, will qualify and benefit from the Head of Household filing status. Eligible Head of Household filers are allowed increased tax benefits. For example, the 2011 federal standard deduction, which is claimed in lieu of itemizing deductions, is $8,500 for Head of Household vs. $5,800 for Single status. Many phase outs of various deductions and credits have higher-income thresholds for Head of Household filers than Single filers, which could result in the Head of Household filer claiming a bigger deduction or credit than a Single filer with the same income. Additionally, the ranges of income are wider for most federal tax rates for Heads of Households than for Singles. For example, a taxpayer with $46,000 of taxable income in 2011 would still be in the 15% tax bracket if filing as Head of Household, but would be in the 25% bracket if filing Single, so the Head of Household filer would pay less tax.
Education Credits – Tax regulations provide that solely for education credit purposes, if a third party makes a payment directly to an eligible educational institution for a student’s qualified tuition and related expenses, the student would be treated as receiving the payment from the third party, and, in turn, paying the qualified tuition and related expenses. Furthermore, qualified tuition and related expenses paid by a student would be treated as paid by the taxpayer if the student is a claimed dependent of the taxpayer. Thus, in the case of divorced parents, the custodial parent will be able to claim the education credit even if the non-custodial parent is the one that actually pays the expense.
Example: If one divorced parent pays qualified tuition to a college for a child, but the other parent has custody of the child (and is eligible to claim the child as a dependent), the custodial parent is treated as having paid the tuition directly to the college and would be the one to claim the credit.
The regulations also provide that if a taxpayer is eligible to but does not claim a student as a dependent, only the student can claim the education credit for the student’s qualified tuition and related expenses.
Medical Expenses – Solely for the purpose of deducting medical expenses, a child of divorced parents is considered to be a dependent of both parents (so that each parent may deduct the medical expenses he or she pays for the child.)
Example – Bob and Jan are divorced and have two minor children. Jan claims the children as dependents and Bob pays their medical insurance and other medical expenses. Under the exception, because Jan claims them as dependents, Bob can claim the medical expenses that he pays.
Kiddie Tax - To prevent parents from placing investments in their children’s names to take advantage of the child’s lower tax rate, Congress several years back created what is referred to as the “Kiddie Tax.” Under the Kiddie Tax, a child’s investment income in excess of an annual floor amount ($1,900 for 2011) is taxed at the parent’s tax rate rather than the child’s. These rules generally apply to children under the age of 19 or those that are full-time students under the age of 24. For divorced or separated parents, the tax code provides the following rules to determine which parent’s return will be used to determine the tax rates used:
• Parents are married: If the child's parents file separate returns, the return of the parent with the greater taxable income is used.
• Parents not living together: If a child's parents are married to each other but not living together, and the parent with whom the child lives (the custodial parent) is considered unmarried (i.e.; lived apart for the last 6 months of the tax year and qualifies for the head of household filing status), the custodial parent’s return is used. If the custodial parent is not considered unmarried, the return of the parent with the greater taxable income is used.
• Parents divorced: If a child's parents are divorced or legally separated, and the parent who had custody of the child for the greater part of the year (the custodial parent) has not remarried, the return of the custodial parent is used.
• Custodial parent remarried: If the custodial parent has remarried, the stepparent (rather than the noncustodial parent) is treated as the child's other parent. Therefore, if the custodial parent and the stepparent file a joint return, that joint return – and not the return of the noncustodial parent – is used.
Filing Status – The marital status of a husband and wife is terminated when the couple is legally separated under a decree of divorce or of separate maintenance. An interlocutory (temporary) decree of divorce doesn't end a marriage until the decree becomes final. A couple living under a legal separation agreement but without any court decree isn't legally separated for tax purposes, because such an agreement could be terminated by the parties upon reconciliation and resumption of cohabitation.
The following are filing options for the various stages of divorce:
Divorce is Final - Once divorced and assuming that they do not remarry, taxpayers will file their returns individually. That generally means they will file as single taxpayers, or if they are the custodial parent of a child, they may qualify to file as Head of Household (see below).
Separated but Divorce Not Final - Taxpayers who are in the process of a divorce but the divorce is not final by the end of the year have the following filing options:
• File Jointly – When taxpayers file jointly, they become jointly and separately liable for the tax on the return. This may not be an appropriate filing status where there is an adversarial divorce action, since the refund or tax liability will be a joint one. The IRS will issue a refund check in the joint names and will generally go after the taxpayer with the ability to pay where there is an unpaid tax liability on the original return or a subsequent audit or adjustment. In addition, once the joint return is filed, it cannot be amended to another filing status after the due date of the original return.
• File Separately – Taxpayers have the option to file individually using the Married Separate filing status (or possibly the Head of Household status – see below), in which case they would file using their own separate income and deductions. However, determining one’s separate income and deductions can quickly become complicated for a number of reasons, such as the couple has children where one only parent can claim the deduction or the taxpayers reside in a community property state and they must split their income earned prior to separation and include their own income after separation. If one spouse itemizes, both must itemize, possibly creating a hardship for the one who would otherwise benefit from using the standard deduction. Unlike filing a joint return, where the taxpayers generally are locked into the married joint status, they can later change their filing status by amending the two married separate status returns to one return filing as Married Joint, if the change is made within three years from the unextended due date of the original return.
A number of tax benefits and provisions are not allowed to be claimed when the Married Separate status is used and the spouses have lived together at any time during the year. These unavailable items include education credits, converting a traditional IRA to a Roth IRA, deducting student loan interest, adoption credit and exclusion of employer-provided adoption benefits, and deducting qualified higher education expenses. Certain income floors and calculations of phaseouts also discriminate against Married Separate filers, including the computation of the amount of Social Security benefits that are taxable.
• Head of Household – Generally, only unmarried individuals may qualify to use the Head of Household filing status. However, a married taxpayer is considered to be unmarried and may use the more beneficial Head of Household status as an alternative to filing Married Separate. To qualify, the taxpayer must live apart from their spouse at least the last six months of the year and pay more than one-half of the cost of maintaining as his or her home a household which is the principal place of abode for more than one-half the year of a child, stepchild or eligible foster child for whom the taxpayer may claim a dependency exemption. A nondependent child will qualify a taxpayer for Head of Household only if the taxpayer gave written consent to allow the dependency to the non-custodial parent.
Marriage Annulled – If a marriage is legally annulled, taxpayers will file as if never married. Returns that were jointly filed prior to the annulment and still open by the statute of limitations should be amended.
Allocation of Jointly Paid Estimated Tax Payments – When filing separate tax returns after making joint estimated tax payments the IRS provides the following rules:
• Spouses Agree Upon Allocation of Payments: One spouse can claim all of the estimated tax paid and the other none, or they can divide it in any other way they agree on.
• Spouses Cannot Agree Upon Allocation of payments: They must divide the payments in proportion to each spouse's individual tax as shown on their separate returns for the year.
Example - James and Evelyn Brown made joint estimated tax payments totaling $3,000. They file separate returns and cannot agree on how to divide estimates. James' tax is $4,000 and Evelyn's is $1,000.
James’ share = 4,000/5,000 x 3,000 = $2,400
Evelyn’s share = 1,000/5000 x 3,000 =$ 600
Property Settlements – When married couples divorce, they must divide up their property between themselves. Many mistakenly think that this results in a sale or purchase of jointly-owned property, which is not the case. No gain or loss is recognized when property is transferred between spouses during marriage. This rule applies also to transfers between former spouses if “incident to a divorce.” A transfer is considered incident to a divorce if it occurs within one year after a marriage ends, or is related to the ending of a marriage (i.e., occurs within 6 years after a marriage ends and the transfer is made under a divorce or separation agreement). A transfer which occurs later than 6 years after a marriage ends can be considered incident to a divorce if the taxpayer can show that legal factors prevented earlier transfer of the property.
Tax Basis of Transferred Property – Knowing the basis of assets such as stock and real estate is necessary to determine gain or loss when the property is sold, as well as for other tax issues, such as computing depreciation of business property. In its simplest form, basis is the price paid to acquire the property, but it can be more complicated when events have occurred that may have increased or decreased the basis. Examples of such events are stock splits or mergers and improvements made to real property. This modified basis is termed the adjusted basis. The basis of the property received in a transfer between spouses or former spouses is the adjusted basis the transferring spouse had in the property. In effect, the recipient spouse has received a gift of the transferred property. The bottom line is that the spouse who retains an item of property in a divorce assumes the same tax basis as the couple had when the property was jointly or separately owned, and therefore assumes the responsibility for any subsequent taxable gain or loss associated with the property when it is later disposed of. This can best be understood by the following example:
Example: Incident to a divorce, Don and Shirley are dividing up their property which consists of a home in which they have $300,000 of equity (value of $550,000 less a $250,000 mortgage). They originally paid $170,000 with $20,000 down and a $150,000 mortgage. After the home appreciated in value, they subsequently took a $100,000 equity loan on the home to purchase a car, pay off credit card debt and go on vacation. They also have a bank account worth $350,000. Shirley wants to keep the home and Don agrees. They decide that Shirley, will take the home ($300,000 equity) along with $25,000 of the cash. Don will take the remaining $325,000 of the bank account cash. On the surface, this would seem like an even division of jointly-owned property. However, two important issues have been overlooked.
(1) If the home was to be sold and the couple was to split the proceeds, both would have shared in the expense of the sale. Assuming a conservative sales expense of 6%, the cost of selling the home would be $33,000 ($550,000 x .06). Thus, by taking the title to the home, Shirley is assuming Don’s $16,500 (50% of $33,000) share of the sales cost based upon the value of the home at the time of the divorce.
(2) When Shirley assumes the ownership of the home, she is also assuming the tax liability for the built-in gain on the property attributed to the period of joint ownership. At the time of the divorce, the property that the couple had originally purchased for $170,000 was worth $550,000. This equates to a built-in gain, after an assumed sales cost of $33,000 of $347,000 ($550,000 - $170,000 – $33,000). Thus, even if Shirley subsequently qualifies for the home gain exclusion, she would be single and only allowed to exclude $250,000 and would end up with a $97,000 ($347,000 -$250,000) taxable gain if she sold the home.
Thus, where Don would have $325,000 of tax-free cash, Shirley’s after-tax and sales cost value of the home is significantly less.
The foregoing example demonstrates the need to consider the tax ramifications carefully to determine an equitable division of property. This can be far more complicated where the taxpayers own businesses, investments, second homes, rental property, etc. Divorce counsel will sometimes overlook the tax issues related to splitting up assets, so taxpayers should consult with a tax professional before proceeding with the allocation of jointly-owned assets.
Qualified Domestic Relations Order (QDRO) – A qualified domestic relations order is a judgment, decree, or order relating to payment of child support, alimony, or marital property rights to a spouse, former spouse, child or other dependent. The order has to contain certain specific information like the amount of the participant’s benefits to be paid to each alternate payee.
If a spouse or former spouse receives retirement benefits from a participant’s plan under a QDRO, the former spouse must report the payments just as though he/she were the plan participant. If the Distribution is from a qualified plan (not including an IRA) The early distribution penalty does not apply, regardless of the alternate payee’s age the taxability is computed by allocating the spouse/former spouse a share of the investment in the contract and figuring the taxable portion accordingly.
If the QDRO distribution is in the form of a lump sum from a pension plan, the alternate spouse payee recipient has the option of immediately paying the tax (but no 10% early withdrawal penalty if it is a qualified plan) on the distribution or deferring the tax into the future by rolling that distribution into his or her IRA or qualified plan. CAUTION: If the distribution is rolled over, then any subsequent distribution will be treated as if they were distributions from the spouse’s own IRA or qualified plan and will be subject to the pre-age 59-½ 10% early withdrawal penalty, unless other exceptions apply. Thus, the recipient of a QDRO distribution who is under age 59-½ and considering rolling the distribution over should carefully consider their pre-59-½ cash needs before executing a rollover. Under such circumstances, you are strongly urged to contact this office to determine in advance the tax implications of both options; also keep in mind that rollovers must be executed within 60 days of the distribution.
If one spouse’s IRA is transferred to the other spouse under the terms of a divorce or separation agreement (not a QDRO), the transfer is not taxable to either spouse. Since the transfer isn’t taxable, the 10% early distribution penalty won’t apply. However, when the receiving spouse takes a distribution from the transferred IRA, it will be taxable and may be subject to the 10% early withdrawal penalty, depending on that spouse’s age and whether any exceptions to the early distribution penalty apply.
Primary Residence – Although the taxpayers’ primary residence will generally be included as part of the divorce property settlement discussed above, there are a number of special tax issues relating to a home:
Home Gain Exclusion – The tax code permits a taxpayer to exclude up to $250,000 of gain from the sale of the taxpayer’s primary residence provided the taxpayer owned and used the home as their primary residence for two of the prior five years. Married taxpayers can exclude up $500,000 if either meets the two-out-of-five year ownership requirement and both meet the two-out-of-five year use requirement. For sales in 2009 and later years, the gain that is excludable may be less than $250,000/$500,000 if the home is used after 2008 as other than a principal residence, such as a vacation home, rental or for other non-qualified use. The exclusion will be limited to the amount of gain not allocated to the non-qualified use period. If your home falls into this category, please contact this office for additional information.
Sold After Division of Property - Divorcing taxpayers should take caution; since their marital status is determined on the last day of the tax year and the home has been transferred to single ownership, the $500,000 exclusion would no longer apply and the exclusion would be limited to $250,000 if sold by a spouse after the division of property. If the home is used as other than a personal residence, the reduced exclusion available to the seller should be taken into account when property divisions are negotiated.
Sold After Divorce But Still Owned By Both - If the home continues to be jointly owned and is sold after the divorce each spouse, provided that spouse separately meets the two-out-of-five year use and ownership requirement, would be qualified for the $250,000 gain exclusion. Thus, if both met the ownership and use requirement, they could exclude up to $500,000 of gain. But see above if the residence has not always been used solely as a principal residence and is sold in 2009 or later.
Sold Before Meeting the Two-Out-of-Five Year Requirements – Tax law provides that taxpayers may qualify for prorated gain exclusion where they do not meet the two-out-of-five year use and ownership requirements and the sale was the result of “unforeseen” circumstances. As an example of a prorated exclusion, a taxpayer has a qualified unforeseen circumstance and only owned and used the home for 18 months. The single taxpayer would be qualified for a gain exclusion of $187,500 (18/24 x $250,000). The tax regulations include a number of safe harbor events that qualify as unforeseen circumstances and among them is a qualified individual's divorce or legal separation under a decree of divorce or separate maintenance.
Transfers Related to Divorce – Where an individual holds property transferred between spouses incident to divorce, the period the individual owns the property includes the period the transferor owned the property. However, the period that the transferor spouse or former spouse used the property is not included in the period that the individual used the property. Thus, a transferee spouse would still have to satisfy the use requirement in order to qualify for the exclusion.
Sale After Ex-spouse Retains Property for Some Period of Time – Frequently, as part of the divorce, a wife or husband (we’ll call them the “in-spouse”) will be granted the use of the home for a specific period of time, usually until children reach maturity. Under these circumstances, the other spouse (we’ll call them the out-spouse) is denied the ability to sell the home and avail themselves of the home gain exclusion. When the home is finally sold, usually some years later, the “out-spouse” would no longer meet the two-out-of-the-last-five year use requirement. A special provision of the tax regulations allows the “out-spouse” to treat the in-spouse’s use of the home as their own, making the home sale exclusion available to the “out-spouse” when the “in-spouse” finally sells the home, provided the “out-spouse” has not taken an exclusion on another home in the prior two years.
First-Time Homebuyer Credit Repayment – For homes purchased after April 8, 2008 and before January 1, 2009 by qualified first-time homebuyers qualified for a refundable tax credit of the lesser of 10% of the purchase price or $7,500. This credit was, in reality, an interest-free loan. If that credit was taken by the taxpayers, they should be aware that in the case of a transfer of the residence to a spouse or to a former spouse incident to a divorce, the credit is not paid back at the time of transfer. Instead, the liability to repay the credit accompanies the home and will become the responsibility of the transferee spouse (and not the transferor spouse) who will be responsible for any future repayments (recapture). This future liability should be taken into consideration when the couple’s property division is being negotiated.
Spousal Buy-Out Debt – Generally a taxpayer can only deduct the interest paid on up to $1,000,000 of home acquisition debt and $100,000 of equity debt. To the extent a taxpayer is subject to the alternative minimum tax (AMT) the equity debt interest provides no tax benefit. Generally taxpayers gain the most tax advantage from having acquisition debt interest. Acquisition debt is defined as debt used to acquire or substantially improve the taxpayer’s primary or second residence. There is a special rule that allows the spouse who retains the couple’s home, and incurs debt secured by the home to buy out the former spouse’s interest in the home, to treat that debt as acquisition debt (up to the $1 million limit) and retain the tax benefits of acquisition debt.
Alimony - Alimony is the term used for payments to a separated or ex-spouse as part of a divorce or separation agreement. The payments are generally taxable to the recipient and tax-deductible by the payer, but are not treated as alimony if the spouses file a joint return with each other. However, because of taxpayer attempts to disguise property settlements and child support as alimony, the tax code includes a stringent definition of alimony. There is one set of rules for defining alimony under decrees and agreements made before 1985 and another set of rules currently in effect. Since this article is dealing with current divorce issues only, the current rules are discussed. For information regarding pre-1985 alimony, please call this office.
Definition of Alimony – To be classified as alimony, payments must meet six conditions. Thus, the payments:
1. must be in cash, paid to the spouse, ex-spouse or a third party on behalf of a spouse or ex-spouse.
2. must be required by a decree or instrument incident to divorce, a written separation agreement, or a support decree. Thus, voluntary payments are not treated as alimony.
3. cannot be designated as child support.
4. are valid alimony only if the taxpayers live apart after the decree. Spouses who share the same household can’t qualify for alimony deductions. This is true even if the spouses live separately within a dwelling unit.
5. must end on the death of the payee.
6. cannot be contingent on the status of a child (that is, any amount that is discontinued when a child reaches 18, moves away, etc., is not alimony).
Payments May Be Designated as Not Alimony - Divorcing spouses can designate that otherwise qualifying payments are not alimony. This is done by including a provision in the divorce or separation instrument that states the payments are not deductible as alimony by the payer and are excludable from the recipient spouse's income. Both spouses must sign the written statement that makes this designation, and the spouse who receives the alimony and excludes it from income must attach a copy of the instrument designating the payments as not alimony to his or her return. The copy must be attached each year the designation applies.
Alimony Recapture- To further prevent property settlements from being disguised as alimony, the tax code also includes what is referred to as alimony recapture, which prevents excess front-loading of alimony payments. Under these rules, which are in effect for the first three post-separation years, alimony recapture may apply when the payments made in the first two post-separation years exceed $15,000. The excess amounts are determined in the third post-separation year, and any excess becomes taxable to the payer. The computation of the excess amount is rather complicated and this office should be contacted if front-loading of alimony is being considered. The recapture rules do not apply if: either spouse dies, the alimony recipient remarries within certain time limits, the payments made are “temporary support payments,” or the payments fluctuate due to conditions beyond the payer’s control because of a continuing liability to pay, for at least 3 years, a fixed part of business income.
Both spouses should exercise care in reporting the correct amounts of alimony received and the amounts of alimony paid. The IRS requires the payer to include both the amount paid and the recipient’s taxpayer ID number on his or her tax return and will match that to the alimony reported as income by the recipient. This matching generally occurs one or two years after the tax returns are filed and, in addition to underpaid tax, substantial penalties and interest can accrue where incorrect amounts are reported.
Alimony & IRA Contributions – Contributions to IRA accounts is limited to the extent a taxpayer has received compensation. Most consider compensation to only include wages, commissions and income from personal services. However, in addition to those, alimony is treated as compensation for purposes of making an IRA contribution (either Traditional or Roth) if the taxpayer otherwise qualifies for an IRA contribution.
Child Support – Child support is not alimony and is not a deductible expense. To keep taxpayers from disguising child support payments as alimony, the definition of alimony specifically states that alimony cannot be designated as child support and cannot be contingent on the status of a child (that is, any amount that is discontinued when a child reaches 18, moves away, etc., is not alimony).
Inheritance Issues
When it comes to inheritances, there is considerable misunderstanding with taxpayers. Many believe that inheritances are taxable. That may or may not be true depending upon what is inherited. For example, if a taxpayer inherits cash, stocks and bonds, or real estate from a decedent, he or she is not taxed on these assets upon receipt (but income such as interest, dividends or rents generated from the inherited assets after the property is transferred to the taxpayer is reportable). On the other hand, if a Traditional IRA is inherited from a decedent (funds on which taxes were never paid by the decedent), the Traditional IRA will generally be taxable to the taxpayer; although, there will be certain options on when to take the taxable income. This discussion explains the role of an executor, the tax treatment for several types of assets that are frequently inherited, the rules regarding tax basis for inherited property, the tax reporting and associated forms likely to be encountered by beneficiaries, and who may claim the deduction when the decedent’s property is donated to charity.• Executor’s Duties and Compensation
• Life Insurance
• Beneficiary Tax Basis
• Inherited IRAs
• Inherited Personal Residence
• Depreciable Assets
• Income in Respect of a Decedent
• Estate’s Income Tax Reporting
• Donating Decedent’s Property to Charity
Executor’s Duties and Compensation
Throughout most of this article, we refer to an “executor” of the estate. By legal definition, an executor is named in a decedent’s will to administer the estate and distribute the decedent’s property as the decedent directed. If no will exists, no executor was named in the will, or the named person cannot or will not serve as executor, a court will appoint an administrator, whose duties and responsibilities are generally the same as those of an executor. For estate tax purposes, the term executor can also include anyone in actual possession of the decedent’s property if no executor or administrator is appointed, qualified and acting within the U.S. A broad term that is sometimes used to describe an executor, administrator or other person who is in charge of the decedent’s property is personal representative. For simplicity, we’ll generally use “executor.”
The primary duties of an executor are to collect all of the decedent’s assets, pay creditors, and distribute the remaining assets to the heirs or other beneficiaries. Other specific duties of the executor include applying for an employer identification number (EIN) for the estate, timely filing required income and estate tax returns (including the decedent’s final Form 1040, plus Forms 1041 and 706 related to the estate), and paying the tax determined up to the date the executor is discharged from duties. The executor, who is oftentimes a friend or relative of the deceased individual, is not required to personally prepare the tax returns or legal documents needed to administer the estate, and generally will hire an attorney and professional tax preparer to assist in these matters. The fees charged by these professionals are paid from the assets of the estate.
Sometimes heirs or beneficiaries become impatient with the executor because they think that the administration of the decedent’s estate is moving too slowly. Beneficiaries need to realize that the executor must work within the timeframes of the courts and attorneys, especially when an estate has to go through the probate process. Additionally, the executor may need to delay the distribution of some or all of the estate’s assets until required tax returns are filed, taxes paid and tax clearances issued by the IRS. It is unusual for an estate to be completely settled in less than one year, and often it can take 18 to 24 months or longer.
Executors generally are eligible to receive compensation for their work, payable from the estate’s assets. In some states, the compensation is based on the value of the estate and may equal that paid to the attorney hired to take care of the estate’s legal matters. Thus, the executor’s fees can be several thousand dollars. All executors or other personal representatives who are compensated by an estate for their services must include those fees in their gross income on their personal tax returns. Professional executors or administrators must also pay self-employment tax on these fees. A person who serves as an executor or administrator in an isolated instance, such as a friend or relative of the decedent, pays self-employment tax on executor fees only if a trade or business is included in the estate’s assets, the executor actively participates in the business, and the fees are related to the operation of the business. If you are the executor of an estate and also the sole beneficiary, you may want to waive any executor fees. By doing so, the net amount of the estate’s assets that will pass to you will increase by the foregone fee, and you will not have to pay income tax on that amount. However, if the estate is subject to estate tax, this strategy may not be appropriate because the estate will lose the benefit of the executor fee deduction, and usually an estate’s tax bracket is higher than the beneficiary’s income tax bracket. Thus, there would be a greater net tax benefit if you receive the executor’s fee, pay tax on that income, and the estate takes a deduction for the fee.
Life Insurance
Life insurance proceeds that you receive because of the insured’s death are not taxable to you unless the policy was turned over to you for a price. This applies even if the proceeds are paid under an accident or health insurance policy or an endowment contract. If the proceeds are received in installments, part of each installment is excludable from your income. The excludable part is figured by dividing the amount held by the insurance company – usually the lump-sum payable at the insured person’s death – by the number of installments to be paid. The portion that is not excludable is taxable as interest income.
Beneficiary Tax Basis
Basis is a tax term that defines the amount of a taxpayer’s investment in a property. For property that is purchased, the initial tax basis is the cost of the property, but that basis can be adjusted up or down by events that occur after the property is acquired. Basis is used for figuring depreciation (on business property) and is the dollar value from which a taxpayer measures his gain or loss when an asset is sold. Generally, when you inherit an asset from a deceased individual’s estate or trust, you receive the asset at its fair market value (FMV) determined as of the individual’s date of death. The inherited basis can be more or less than what the decedent paid for the property. This change in basis is sometimes referred to as a step-up or step-down in basis. Thus, if for example, you inherited 100 shares of stock that the decedent originally purchased for $40 a share (total cost $4,000) that is worth $100 per share (total value $10,000) when the decedent died, you will receive the stock free of any income tax and will have an inherited basis of $10,000. Any future gain or loss will be measured from the $10,000 basis.
As is the case with property that is purchased, the basis of inherited property may have to be adjusted during the beneficiary’s ownership period. Situations that require basis adjustment include stock splits, nontaxable dividend distributions, improvements to real property, and casualty losses, among others. The important point is that, for property acquired from a decedent, the starting place for making any required adjustments is the initial inherited basis.
CAUTION 2010: Legislation enacted nearly 10 years ago repeals the estate tax for individuals dying in 2010, and then brings it back for those dying after 2010. Although many had thought Congress would revoke the repeal for 2010 and keep the tax at 2009’s level that has not happened yet. Without Congressional action (there are active legislative discussions taking place), the basis for items inherited in 2010 will be based upon a more complicated “modified carryover basis”. Thus, for 2010, inherited basis becomes the lesser of the decedent’s adjusted basis, or the FMV at the date of death plus an allowable aggregate basis increase of $1,300,000 plus loss carryovers and built in losses, and if applicable a spousal $3,000,000 property basis increase.
Joint Ownership - A beneficiary who is a joint owner of a property with the decedent will have a basis made up of two parts: his or her own basis for the original ownership portion and an inherited basis for the part that was inherited. For example, a father and son each owned 50% of a lot they purchased together for $10,000 several years ago. At the time of the father’s death in 2009, the lot was worth $20,000 and the son was the beneficiary of the father’s share of ownership. The son’s new basis in the property is $15,000 (50% of $10,000 plus 50% of $20,000).
Community Property - A husband and wife who are residents of a community property state* generally are considered to each own half of the community property. At the death of either spouse, the total value of the community property – even the surviving spouse’s part – becomes the basis of the entire property. This rule applies when at least half the value of the community property interest is includible in the decedent’s gross estate, whether or not the estate must file a return. For example, a husband and wife owned community property that had an adjusted basis of $100,000 at the time the husband died in 2009. The fair market value at his date of death was $150,000, and half the FMV was includible in the husband’s estate. The husband’s will named his sister as the beneficiary of his half of the property. The wife and the sister will each have an inherited basis of $75,000. If the wife was the sole beneficiary, her new basis as of the husband’s date of death would be $150,000.
*Community property states are Alaska (by election), Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin.
Valuation Other than at Date of Death – Under some circumstances, the executor of the decedent’s estate may choose to use the fair market value on the “alternate valuation date” instead of the decedent’s date of death. The alternate valuation date is the date six months after the date of death. This alternate date is chosen when using the values of all assets in the estate at that date will produce a lower estate tax than when the date of death valuation is used. While using the alternate valuation saves estate tax, it means that the beneficiary’s basis of inherited property will be lower than if the date of death valuation applied. Thus, when the beneficiary sells the inherited property in the future, his or her gain will be more (or the loss will be less) than if the date of death FMV applied. The beneficiary is required to use the same basis that the executor used for the estate tax return. The executor should provide a record of the inherited basis for each asset the beneficiary receives, regardless of which valuation date is used. Note: The beneficiary’s basis in assets inherited from a decedent dying in 2010 is determined by a different set of rules. See CAUTION 2010 above.
Holding Period of Inherited Property – Gains from the sale of capital assets such as stocks, bonds, unimproved real estate, etc., that are held “long-term” are given beneficial tax treatment. This special treatment is in the form of lower tax rates. To qualify as long-term, generally an asset has to be held more than one year. An exception is made for inherited assets, which automatically receive long-term treatment regardless of how long the decedent or the beneficiary owned the property. Note: The beneficiary’s holding period in assets inherited from a decedent dying in 2010 may be determined differently if the decedent’s basis is carried over. See CAUTION 2010 above.
Inherited IRAs
A number of factors are involved in determining how much, if any, of an IRA account that you inherit is taxable to you, and when the taxable amount is includible in your income. These factors include which type of IRA (Traditional or Roth) is inherited, who the beneficiaries are (spouse, non-spouse, trust or estate), the deceased IRA account owner’s age at death, and whether or not distributions from the IRA were required to start before the decedent’s death. With a Traditional IRA, the account owner is required to begin taking annual minimum distributions by April 1 of the year following the year in which he or she reaches age 70½. Roth IRA account owners are not required to take distributions during their lifetimes. The following situations explain the options available to beneficiaries of these IRAs.
Traditional IRA inherited by spouse and decedent owner was under 70½: – If the spouse takes a distribution of the IRA account as a lump-sum, the spouse will pay income tax on the distribution on the tax return for the year of the distribution, but no penalty for “early” withdrawal will be due, even if the spouse is under age 59½.
• Transfer to spouse’s own existing or new IRA – This choice is available only if the spouse is the sole beneficiary of the IRA. If the deceased account owner had not already taken the required minimum distribution (RMD) for the year of death, the spouse must do so. A spouse who is under age 59½ is regulated by the same distribution rules as if the IRA had been his or hers originally, so distributions cannot be taken before age 59½ without incurring the 10% penalty (except for the required year-of-death RMD or if one of the general exceptions applies).
• Transfer to Inherited IRA held in own name – The annual RMD based on life expectancy must begin no later than December 31 of the year following the original account owner’s death. Also, if no RMD had been taken by the decedent in the year of death, an RMD must be taken from the Inherited IRA by December 31 of the year the original account owner died. The annual distributions are spread over the longer of the surviving spouse’s single life expectancy using his or her age in the calendar year following the year of death and refigured each year, or the deceased account owner’s remaining life expectancy. Each distribution is taxed, but the 10% early distribution penalty does not apply. If there are other beneficiaries besides the spouse, separate accounts must be established by the end of the year following the year of death; otherwise, distributions will be based on the life expectancy of the oldest beneficiary, which will cause the amount of the distribution to be greater than otherwise required for the younger beneficiaries.
Traditional IRA inherited by spouse and decedent owner was 70½ or older:
• Lump-sum distribution – Same result as for a decedent who was under 70½ (see above).
• Transfer to spouse’s own existing or new IRA – This choice is available only if the spouse is the sole beneficiary of the IRA. If the deceased account owner had not already taken the required minimum distribution (RMD) for the year of death, the spouse must do so. A spouse who is under age 59½ is regulated by the same distribution rules as if the IRA had been his or hers originally, so distributions cannot be taken before age 59½ without incurring the 10% penalty (except for the required year-of-death RMD or if one of the general exceptions applies).
• Transfer to Inherited IRA held in own name – The annual RMD based on life expectancy must begin no later than December 31 of the year following the original account owner’s death. Also, if no RMD had been taken by the decedent in the year of death, an RMD must be taken from the Inherited IRA by December 31 of the year the original account owner died. The annual distributions are spread over the longer of the surviving spouse’s single life expectancy using his or her age in the calendar year following the year of death and refigured each year, or the deceased account owner’s remaining life expectancy. Each distribution is taxed, but the 10% early distribution penalty does not apply. If there are other beneficiaries besides the spouse, separate accounts must be established by the end of the year following the year of death; otherwise, distributions will be based on the life expectancy of the oldest beneficiary, which will cause the amount of the distribution to be greater than otherwise required for the younger beneficiaries.
Traditional IRA inherited by non-spouse and decedent owner was under 70½:
• Lump-sum distribution – Same result as if the spouse was beneficiary (see above).
• Transfer to Inherited IRA held in own name, 5-year withdrawal – Distribution can be spread over time, but all of the assets in the account need to be distributed by December 31 of the fifth year after the year in which the account owner died. Distributions are taxed as received, but are not subject to the 10% early withdrawal penalty.
• Transfer to Inherited IRA held in own name, distributions over life expectancy – A required minimum distribution based on the beneficiary’s life expectancy must begin no later than December 31 of the year following the year of the original account owner’s death. The annual distributions are spread over the beneficiary’s single life expectancy based on his or her age in the calendar year following the year of death and reduced by one each year thereafter. If there are multiple beneficiaries, separate accounts should be established by December 31 of the year following the year of death in order for each beneficiary to use his or her own life expectancy. Otherwise, life expectancy is based on that of the oldest beneficiary. Each distribution is taxed, but the 10% early distribution penalty does not apply.
Traditional IRA inherited by non-spouse and decedent owner was age 70½ or older:
• Lump-sum distribution – Same result as if the spouse was beneficiary (see above).
• Transfer to Inherited IRA held in own name - The annual RMD based on life expectancy must begin no later than December 31 of the year following the original account owner’s death. Also, if no RMD had been taken by the decedent in the year of death, an RMD must be taken from the Inherited IRA by December 31 of the year the original account owner died. The annual distributions are spread over the longer of the beneficiary’s single life expectancy using his or her age in the calendar year following the year of death and reduced by one each year, or the deceased account owner’s remaining life expectancy. If there are multiple beneficiaries, separate accounts should be established by December 31 of the year following the year of death in order for each beneficiary to use his or her own life expectancy. Otherwise, life expectancy is based on that of the oldest beneficiary. Each distribution is taxed, but the 10% early distribution penalty does not apply.
Traditional IRA with Basis – Generally, while the account owner was alive, he or she would have deducted the contributions made to a Traditional IRA on the income tax returns for the years of the contributions. However, if the taxpayer participated in an employer’s retirement plan and was not eligible to deduct IRA contributions because of income limitations, he or she was still allowed to contribute to the IRA but had to designate the contribution as being nondeductible. In this situation, the nondeductible contribution amounts became the taxpayer’s basis in the IRA, since tax had already been paid on the funds used to make the contributions. If you inherit a traditional IRA from a person who had a basis in the IRA because of nondeductible contributions, that basis remains with the IRA. This means that each distribution you take from the inherited IRA will be partly nontaxable. Unless you are the decedent’s spouse and choose to treat the IRA as your own, you cannot combine this basis with any basis you have in your own Traditional IRAs or others you may have inherited. Form 8606 is used to figure your taxable and nontaxable portions of the IRA distribution. How will you know what the decedent’s IRA basis is? This information can be found on the Forms 8606 the decedent filed with his or her tax returns. The executor for the decedent’s estate should have access to that information and should make it available to you as the beneficiary of the IRA.
Federal Estate Tax Deduction – A beneficiary may be able to claim a deduction for estate tax resulting from certain distributions from a Traditional IRA. The beneficiary can deduct the estate tax paid on any part of a distribution that is income in respect of a decedent, which includes IRAs. The deduction is taken for the tax year the income is reported. See more about income in respect of a decedent below.
Roth IRAs – Roth IRAs are not subject to the annual required minimum distribution rules during the account owner’s lifetime. But after the owner’s death, distributions may need to be made. Roth IRA distributions, whether to a living owner or a beneficiary, are made up of after-tax contributions and earnings. Contribution amounts are always distributed tax-free, while earnings may or may not be taxable. If the Roth account was open for at least five years at the time the account owner died, earnings are distributed tax- and penalty-free. If the earnings are distributed before the account has been open for 5 years, the earnings are taxable, but penalty-free. (The IRS has specific “ordering” rules that determine how much of a distribution consists of contributions or earnings.) If the beneficiary chooses not to take a lump-sum distribution of the Roth IRA, the remaining distribution choices are as follows:
• Spousal transfer - A spouse who is the sole beneficiary of a Roth IRA may transfer the assets into his or her own existing or new Roth IRA and is then regulated by the same rules as if the IRA had been his or hers originally. Distributions of earnings will be taxable until the spouse reaches age 59½ and the account is at least five years old. Under this arrangement, the spouse is not required to take distributions from the Roth IRA while living.
• Inherited IRA, 5-year withdrawal – The assets are transferred into an Inherited IRA held in the beneficiary’s name. Distributions can be spread over time, but all assets must be withdrawn by December 31 of the fifth year after the year in which the account owner died. If distributions are taken during the five-year, post-death period, they will not be taxed provided that the five-year account holding period has been met.
• Inherited IRA, life expectancy withdrawal – Assets are transferred into an Inherited Roth IRA held in the beneficiary’s name. For non-spouse beneficiaries, distributions must begin no later than December 31 of the year following the year of death and are spread over the beneficiary’s single life expectancy. A spouse who is the sole beneficiary has the option of postponing distributions until the decedent would have reached age 70½, if later. If there are multiple beneficiaries, they need to establish separate accounts by December 31 of the year following the year of death in order to use their own single life expectancies. The 10% early withdrawal penalty does not apply.
Trust or Estate as Beneficiary – Special rules apply when the IRA beneficiary is a trust or an estate, and are beyond the scope of this discussion.
Inherited Personal Residence
Individuals are allowed to exclude gain on the sale of their personal residence if they have owned and used (lived in) the property as their principal residence for two years during the five years immediately prior to its sale. The exclusion is limited to $250,000 ($500,000 for taxpayers filing a joint return where either spouse meets the ownership test and both meet the use test). If the sale of a personal residence, or any other personal-use property, results in a loss, the loss is not deductible. The rules when a personal residence is inherited are as follows:
• Basis and holding period – The basis of the property will be the fair market value at the date of the owner’s death or the alternate valuation date, if it is chosen by the executor or personal representative. The holding period is automatically long-term. But see "Caution" above for deaths after 2009.
• Use of exclusion by non-spouse beneficiary – If a non-spouse beneficiary inherits what had been the personal residence of the decedent, and then sells the property, generally the home sale gain exclusion will not apply because the beneficiary won’t meet the 2-of-5 years’ ownership and use tests. If the beneficiary moves into the home, and then uses it as his or her own personal residence, the gain exclusion can be claimed if the 2-of-5 years’ tests are met when the home is sold. (Note: A law change currently on the books and effective for property acquired from a decedent dying during 2010, will entitle a beneficiary to the home sale gain exclusion, determined by taking into account the decedent’s ownership and use.)
• Surviving spouse sells at gain – In most cases, the surviving spouse will inherit the home in which the couple lived. It’s not unusual for the surviving spouse to sell the home within a short period of the decedent’s death, in order to downsize, move closer to family, or go into a retirement facility. In the case of an unmarried individual whose spouse is deceased on the date of the sale of the home, the period the surviving spouse owned and used the property includes the period the deceased spouse owned and used the property before his or her death. This provision benefits a surviving spouse who was only recently married to the decedent who had been the home’s owner or in cases where the decedent had sole title to the home.
A surviving spouse (who is unmarried) qualifies for the up-to-$500,000 exclusion if the home is sold no later than the second anniversary of the spouse’s death and either spouse meets the ownership and use requirements. Absent this rule, the surviving spouse would be limited to an exclusion of $250,000 unless the home was sold in the year of death. However, it would be an unusual circumstance in today’s housing market for even a $250,000 exclusion to be too little to cover the gain for a home sold within two years of the spouse’s death, considering the basis step-up the surviving spouse likely received.
• Loss allowed on sale of inherited home – A beneficiary who inherits the residence of a decedent, and who sells the property soon thereafter, may sell it for close to the appraised value as of the date of death, which would result in little gain or loss. However, the beneficiary will usually sell the residence through a broker and will have substantial sales costs. These sales costs quite often translate into a large loss on the sale. Normally, the loss upon a sale of a personal residence is not deductible. However, the courts have ruled favorably for beneficiaries selling inherited residences at a loss, allowing a capital loss where the beneficiary immediately attempts to rent or sell the property, or where a beneficiary who was living in the house at the decedent’s death, moves out as soon as other quarters are located. The character of the property has changed from being personal-use property, which it was to the decedent, to investment property of the beneficiary, thus qualifying for a long-term capital loss if sold at a loss.
Depreciable Assets
Depreciation is one of the “events” that affects basis; when a taxpayer has recovered part of his or her investment through a depreciation deduction, the basis must be reduced by the amount of the deduction. However, if you inherit property that the decedent had been depreciating (because he or she had used it in a business or rental activity), the inherited basis of the property may or may not be affected by the prior depreciation that was claimed. If the decedent was the sole owner of the property and died prior to 2010, the inherited basis is the full fair market value at the date of death (or the alternate valuation date, if applicable) – that is, no adjustment is required for the depreciation allowed while the decedent was alive. The inherited basis from decedents dying in 2010 is determined by a more complicated set of rules (see CAUTION 2010 earlier in this article). If the property continues to be used for business or rental purposes, depreciation starts anew based upon the inherited basis.
As explained above under “Beneficiary Tax Basis,” when the decedent had jointly owned the property with another individual, the post-death basis is made up of two parts; the surviving tenant’s part of the original basis plus the value of the portion of the property included in the decedent’s estate. For depreciated property, the combined new basis is also reduced by the depreciation that had been allowed to the surviving tenant; the decedent’s previously claimed depreciation is ignored. For example, Mother and Son invested $60,000 each for a rental property that they owned as joint tenants with the right of survivorship. Up to the date of Mother’s death, depreciation of $20,000 had been claimed. The fair market value at Mother’s date of death was $200,000. The inherited basis of the property is $150,000 ((50% x $120,000) (50% x $200,000) - (50% x $20,000)).
If the beneficiary and the decedent jointly owned the property, and the beneficiary continues to use the property for business or rental purposes after the co-owner’s death, the beneficiary continues depreciating his or her adjusted basis under the same method used in previous years. Depreciation on the part of the basis inherited from the decedent starts anew as of the date of death using the modified accelerated recovery system (MACRS).
A surviving spouse who inherits community property from his or her deceased spouse that was used for business or rental purposes does not reduce the inherited basis by any portion of the depreciation attributable to the period prior to the spouse’s death. The entire new basis (less any land portion if the property is real estate) is depreciable.
Income in Respect of a Decedent
Income a decedent would have received had he or she not died but that was not includible on the decedent’s final income tax return (because it had not been received) is called “income in respect of a decedent” (IRD). Examples of IRD are wages and other compensation for personal services earned but not yet paid as of the date of death; amounts due and owing based on the sale of farm crops or livestock; unpaid interest, investment income, rents and royalties; income from pass-through entities such as partnerships; post-death payments on pre-death installment sales; taxable portion of inherited IRAs; and Roth IRAs to the extent earnings are taxable.
Deductions in Respect of a Decedent – Business expenses, income-producing expenses, interest and taxes for which the decedent was liable but that weren’t properly allowable as a deduction on the decedent’s final income tax return are deductible, when paid, by the beneficiary of the property if the estate wasn’t liable for the obligation.
Estate Tax Deduction Mitigates Double Taxation - Income in respect of a decedent is included in the decedent’s estate tax return and then also becomes taxable for income tax purposes when it is later collected by the estate or beneficiary. If estate tax was paid on this income, an income tax deduction is allowed to the IRD recipient for the estate tax paid on the income. The deduction is claimed only for the same tax year in which the IRD must be included in the recipient’s income. An individual claims the deduction as a miscellaneous itemized deduction, not subject to the 2% of AGI limit, and it is also allowed as a deduction for alternative minimum tax purposes. If you are a beneficiary who is required to include IRD in your income, you should be sure to obtain a copy of the estate’s Form 706 from the executor so that you or your tax return preparer will have all of the information necessary to calculate the estate tax deduction.
Estate’s Income Tax Reporting
During the period from an individual’s date of death until that individual’s assets have all been passed into the hands of the heirs and beneficiaries, income earned by those assets must be accounted for by the estate (or trust if so established by the decedent’s will or a trust agreement). The estate is a taxable entity separate from the decedent; it comes into existence upon the death of the decedent and lasts until all of the assets have been distributed to the heirs and beneficiaries.
Like an individual, an estate must file an annual income tax return (Form 1041) if its income exceeds a filing threshold amount (currently $600). The executor has the option of using a month ending other than December 31 as the end of the estate’s tax year. (Generally, trust returns must have a December 31 year-end, but under some circumstances the trustee can elect to have the trust treated like an estate and use other than a calendar year-end.)
Who Pays the Income Tax? The income tax liability of an estate attaches to the assets of the estate. If the income is distributed, or must be distributed, during the current tax year, the income is reportable by each beneficiary on his or her individual income tax return. But if the income does not have to be distributed, and is not distributed but is instead retained by the estate, the income tax on the income is payable by the estate. Should the income be distributed later without the tax having been paid, the beneficiary can be liable for the tax to the extent of the value of the estate’s assets received. The estate’s income is taxed either to the estate or the beneficiary, but not both. Other than in the final year of the estate, when the beneficiaries must report any taxable income, it is generally at the executor’s option whether the income is distributed to the beneficiaries. Recipients of “specific bequests” generally do not have to pay tax on any portion of the income earned by the estate. These concepts are illustrated in the following example:
Example: Father died on June 30, 2008. Per his will, Cousin is to receive $10,000, and after paying any estate tax liability, funeral expenses, last-illness expenses, and other debts, his Daughter and Son each are to receive 50% of the remaining estate. Father’s estate consisted of savings accounts and stocks (no real estate). The executor of the estate selected a year-end of January 31, 2009. During the period from Father’s death through January 2009, the assets of the estate earned $5,000 of interest income and $2,000 of stock dividends. Neither this income nor any of the estate’s assets were distributed to Cousin, Daughter or Son by January 31. The executor must file a Form 1041 that reports the $7,000 of income and will pay the tax on that income from the assets of the estate. After getting the probate court’s approval to distribute the assets of the estate, the executor does so on July 31, 2009. The interest and dividend income earned from February 1 through the date of distribution is $6,000. Since the estate’s assets, and income earned since Father’s death, are passed on to Daughter and Son, they would each be responsible to include $3,000 of income on their individual returns. Cousin receives $10,000 from the estate, but does not receive any of the income, and thus pays no tax on it. The executor will file a final Form 1041 Income Tax Return for the estate for the period February 1, 2009 through July 31, 2009. This return will show that the income has been distributed to the beneficiaries and is not taxable to the estate.
Commonly, the executor will pay attorney fees and other expenses during the last tax year of the estate. If these expenses have not already been claimed on the Estate Tax Return, they can be used to offset the income earned during the same period. If the expenses exceed the income, the excess deduction is passed on to the beneficiaries to use on their income tax returns. In that case, none of the income earned during the final reporting period is taxable to the beneficiaries. The final-year excess estate deductions are deductible on each beneficiary’s individual income tax return as a miscellaneous itemized deduction subject to the 2%-of-AGI limitation.
Form 1041, Schedule K-1 – When distributions are made to the beneficiaries, the amount of income or deductions reportable by each beneficiary on their own Form 1040 is shown on Schedule K-1 of the estate’s income tax return, Form 1041. The executor is required to provide each beneficiary a copy of his or her Schedule K-1 by the date the Form 1041 is filed. For the K-1s to be accurately completed, each beneficiary is required to provide their taxpayer identification number (Social Security number) to the executor. In the example above, Daughter and Son would each receive a K-1 from the executor, but no K-1 would be prepared for Cousin.
Donating Decedent’s Property to Charity
Generally, an individual will leave instructions to the estate executor in his or her will as to the desired disposition of personal property owned by the decedent at death. This may include identifying specific items to go to specific individuals, or that all of the decedent’s personal property is to be divided amongst the heirs, or that it should be disposed of as seen fit by the executor. Often, the property ends up being donated to a charity. These post-death donations are not deductible on the decedent’s final income tax return, and do not qualify to be deducted on the estate tax return unless the decedent’s will identified the charity to which the donation was to be made.
If you received personal property from a decedent’s estate and then donated it to a qualified charitable organization, you may be able to claim a charitable deduction as an itemized deduction on your income tax return. The value (basis) of the contributed property for the purpose of calculating the deduction will be the fair market value of the property as of the decedent’s date of death (or alternate valuation date, if applicable). Caution: In the case of decedents dying in 2010 the value may not be the FMV and instead may be some other value as determined in the estate under complicated rules that apply to 2010 (See CAUTION 2010 earlier in this article). The executor, when making an inventory of the decedent’s assets, should also have determined the inherited value of the personal property, so you may need to confer with the executor to obtain this information. The IRS has stringent rules related to non-cash donations, which are summarized next.
Deductions of Less Than $250 – If you claim a non-cash contribution for donation to a qualified organization of property such as used clothing or furniture with a value less than $250, you must get and keep a receipt from the charitable organization showing:
1. The name of the charitable organization,
2. The date and location of the charitable contribution, and
3. A reasonably detailed description of the property that was donated.
However, you are not required to have a receipt where it is impractical to get one, such as when the property was left at a charity’s unattended drop site.
Deductions of At Least $250 But Not More Than $500 - If you claim a deduction of at least $250 but not more than $500 for a non-cash charitable contribution, you must have and keep an acknowledgment of the contribution from the qualified organization. If the contributions were made by more than one contribution of $250 or more, you must have either a separate acknowledgment for each or one acknowledgment that shows the total contribution. The acknowledgment(s) must be written and include:
1. The name of the charitable organization,
2. The date and location of the charitable contribution,
3. A reasonably detailed description (but not necessarily the value) of any property contributed,
4. Whether or not the qualified organization gave you any goods or services as a result of the contribution (other than certain token items and membership benefits), and
5. If goods and or services were provided to you, the acknowledgement must include a description and good faith estimate of the value of those goods or services. If the only benefit received was an intangible religious benefit (such as admission to a religious ceremony), that generally is not sold in a commercial transaction outside the donative context, the acknowledgment must say so and does not need to describe or estimate the value of the benefit.
Deductions Over $500 But Not Over $5,000 - If you claim a deduction over $500 but not over $5,000 for a non-cash charitable contribution, you must have the same acknowledgement and written records as for contributions of at least $250 but not more than $500 described above. In addition, the records must also include:
o How the property was obtained. For example, by purchase, gift, bequest, inheritance or exchange.
o The approximate date the property was obtained or, if created, produced, or manufactured by the taxpayer, the approximate date the property was substantially completed. (For property acquired from a decedent, this is the date of death, not the date that you actually gained physical control of the property.)
o The cost or other basis, and any adjustments to the basis, of property held less than 12 months and, if available, the cost or other basis of property held 12 months or more. (Generally, this will be the inherited value of the property at the date of death of the decedent, unless the alternate valuation date is used for estate tax purposes. If you have made improvements to the property, increase the inherited basis by your costs.)
Deductions Over $5,000 –Special rules apply related to contributions over $5,000; please confer with your tax advisor regarding the documentation requirements for the particular contribution before making the contribution.
With the exception of vehicle contributions (see below), charitable gift acknowledgements must be obtained before the earlier of the date you file your return for the year you make the contribution, or the due date, including extensions, for filing your return.
Additional Rules - Besides the recordkeeping and reporting rules noted above, the IRS has additional requirements when used vehicles, clothing or household items are donated:
• Vehicle Donations - The deduction for motor vehicles for which the claimed value exceeds $500 is dependent on the charity’s use of the vehicle. If the charity sells the vehicle, generally the donor’s charitable deduction is limited to the amount of the gross proceeds from the charity’s sale.
When the deduction claimed for a donated vehicle (car, boat, plane) exceeds $500, IRS Form 1098-C (or other statement containing the same information as Form 1098-C) furnished by the charitable organization must be attached to the filed tax return. Without the 1098-C or other statement, no deduction is allowed. When the charity sells the vehicle, the Form 1098-C (or other statement) must be obtained within 30 days of the sale of the vehicle. Otherwise, the Form 1098-C (or other statement) must be obtained within 30 days of the donation.
• Clothing and Household Goods Contributions - No deduction is allowed for a charitable contribution of clothing or household items unless the clothing or household item is in:
o Good used condition, or
o Better.
In addition, the IRS may deny a deduction for any item with minimal monetary value, such as used socks or undergarments. A deduction may be allowed for a charitable contribution of an item of clothing or a household item not in good used condition or better if the amount claimed for the item is:
o More than $500, and
o You include with your return a qualified appraisal with respect to the property.
• Household Items - Includes furniture, furnishings, electronics, appliances, linens, and other similar items. Food, paintings, antiques, and other objects of art, jewelry and gems, and collections are excluded from the provision.
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