When someone dies, their property transfers to their estate to pass through probate and be distributed according to the decedent’s will. Estates are responsible for paying final taxes before divvying up the property to heirs. The federal government imposes a tax on high net-worth estates, which are those over $5.25 million in 2013, but it does not tax inheritance passed on to heirs. States can set their own laws regarding estate and inheritance taxes.
Only eight states impose an inheritance tax in 2013. Nebraska, Iowa, Indiana, Kentucky, Tennessee, Pennsylvania, Maryland and New Jersey tax up to 18 percent of an heir’s portion of the estate. Survivors don’t receive their inheritance until the estate is settled, a process that includes paying estate taxes. Until a survivor receives her inheritance, she doesn’t owe and cannot pay any inheritance tax. Estates cannot deduct paid inheritance tax because inheritance taxes are incurred after the estate is settled.
While the federal government provides a generous exemption amount, increasing the number of estates that fail to incur any estate taxes, fifteen states and the District of Columbia levy their own death taxes. State-level estate taxes often have far lower exemptions, many around $1 million, which can include a much larger number of estates. State taxes can change more readily than federal taxes, and some tax experts anticipate more states might levy their own estate taxes in response to changes in how federal estate tax funds are distributed.
The size of a person’s taxable estate depends on the fair market value of the property the person has a right to transfer at the date of his death. The total value of all transferrable property forms the gross estate, from which the person responsible for administering the estate must make certain adjustments to arrive at the taxable estate. After subtracting deductions, such as administrative expenses and property passed to spouses and qualified charities, the value of gifts made over the taxpayer’s lifetime is added back to arrive at the taxable estate.
Estate planning seeks to reduce the amount of estate and inheritance taxes due to carry out the taxpayer’s will. While a taxpayer who donated his entire estate to charity would not owe any estate taxes, nor would his heirs owe any inheritance taxes, his heirs would have no inheritance. Estate taxes can be reduced by splitting the estate between both spouses to maximize the exemption amount. For example, a couple with a $9 million estate would owe estate tax on $3.75 million if the property were in one spouse’s name. By splitting the estate between the spouses, however, each spouse has an estate of $4.5 million, which is below the exemption amount. Other strategies include charitable bequeaths to offset estimated estate taxes and transferring real property through life estates to change inheritances into gifts.
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