Commentary: Four steps to navigating your changed tax situation
By Bill Bischoff
Last Update: 7:00 AM ET Feb 27, 2013
If your spouse died last year, it of course affects your 2012 federal income tax return. But there are other tax implications as well. Here are four of the most important things to know.
1. You can still file a joint return for 2012.
Unless you remarried by Dec. 31, you were technically single at the end of last year, for federal income tax filing purposes. Even so, youre still allowed to file a final joint Form 1040 with your deceased spouse for 2012 and thereby benefit from the more taxpayer-friendly rules for joint filers. That final joint return will include your deceased spouses income and deductions up to the time of death, plus the income and deductions of the surviving spouse (that would be you) for the entire year.
2. You get a basis step-up for inherited assets.
If you appreciated inherited capital gain assets such as securities and real estate from your deceased spouse, youre allowed to increase the federal income tax basis of those assets to reflect their fair market value (or FMV) as of the date of death. Alternatively, you can use the FMV as of six months after the date of death, if the executor of your deceased spouses estate (probably you) makes that choice. (Source: Internal Revenue Code Section 1014(a).) When you sell an inherited asset that has received a basis step-up, youll only owe federal capital gains tax on post-death appreciation, if any.
- If you and your spouse owned one or more homes together, the tax basis of the ownership interest that belong to your spouse (usually half) is stepped up.
- If you and your spouse owned one or more homes or other capital gain assets as community property in one of the nine community property states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin), the tax basis of the entire asset is stepped up to FMV (not just the half that belonged to your deceased spouse). This weird-but-true rule means you can sell assets inherited from your spouse and only owe federal capital gains tax on the post-death appreciation, if any. (Source: Internal Revenue Code Section 1014(b)(6).)
3. You get a bigger home sale gain exclusion but only for a while.
An eligible unmarried individual can exclude from federal income taxation up to $250,000 of gain from selling a principal residence. Married joint filers can exclude up to $500,000. However, you, as the surviving spouse, are not allowed to file a joint return for years after the year during which your spouse died (unless you remarry). Even so, an unmarried surviving spouse is allowed to claim the larger $500,000 joint-filer gain exclusion for a principal residence sale that occurs within two years after the spouses death. This is a beneficial rule, but mind the deadline. Since the two-year period begins on the date of your spouses death, a sale that occurs in the second calendar year following the year of death but more than 24 months after the date of death will not qualify for the larger $500,000 joint-filer gain exclusion. On the other hand, if you sell during the calendar year after the year of your spouses death, you will automatically be within the two-year period.
Of course, being eligible for the larger joint-filer gain exclusion wont matter if the gain from selling your home is $250,000 or less. Thats certainly possible even with a highly appreciated home, because the basis of any portion of the home inherited from your deceased spouse will be stepped up. And if the home was owned as community property, the basis of the entire home will be stepped up, as explained earlier.
4. You must follow the required minimum distribution rules for inherited retirement accounts.
If you inherited your deceased spouses IRA or qualified retirement plan account (like a 401(k) account), be aware that the so-called required minimum distribution rules apply to the inherited account balance. Depending on your spouses age when he or she died and your own age, you may have to take a required distribution this year and pay the resulting income tax hit. Youll usually get better required minimum distribution tax results if you choose to treat the inherited account as your own account. For details on the required minimum distribution rules for surviving spouses, see: Inheriting Your Spouses IRA (Part 1) and Inheriting Your Spouses IRA (Part 2).
Warning: You cant afford to ignore the required minimum distribution rules. Failure to withdraw the required minimum amount for any year exposes you to a 50% IRS penalty. The penalty is charged on the difference between the required amount for the year and the amount actually withdrawn during the year, if anything. The 50% penalty is one the harshest punishments in our beloved Internal Revenue Code, and it can stack up year after year until you start getting things right.
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