When Your Client’s Spouse Dies: 6 Tax Issues

If you work in the tax world for very long, you will eventually see tragedy through your clients’ eyes. One issue that has several tax implications that must be navigated is the death of a spouse. While the family grieves, as a tax professional, you must take action as soon as you can.

Below are some actions and issues that should be considered:

First, examine the global picture of the family finances. Are there children under 18, is there a will or trust, are you aware of any life insurance, where are the different investments the family owns, and is the spouse an owner of a business?

All of these situations impact the tax decisions the family will have to make, and they may have to make them in a relatively short amount of time and will appreciate your guidance.

When the tax return for the couple is filed, and so long as the surviving spouse did not remarry in the same year, the surviving spouse can use the filing status “married filing joint.” This is important, as the IRS estimates that 25 percent of all surviving spouses use “single” in the year of a spousal death.

Filing joint gives the couple better tax rates, as well as more lucrative deductions and exemptions, and should be used in the year of death unless a good reason exists otherwise. In addition, the surviving spouse can file as a qualifying widow or widower – this extends the benefits of filing joint for another two years.

If the deceased owns investments or other interests, notify the parties (brokerage advisor, other business owners, etc.), as that income is more than likely to be reported to the estate now and not to the taxpayer personally. This may be of particular interest if the estate is to be distributed to beneficiaries that are not a surviving spouse, as those amounts may now be taxable to the beneficiary, and not the estate or surviving spouse.

Inherited assets that have appreciated (like securities and capital gain assets) will now have step-up basis, and the beneficiary will only have to pay gains on additional appreciation. Alternatively, you can also use the FMV six months after death to determine the basis for the step-up.

Accounting professionals need to help evaluate this issue carefully – there can be a great deal of future tax saved by making a thoughtful analysis of which basis to step-up and when.

When it comes to the couple’s primary home, married couples are usually allowed an exclusion of up to $500,000 if they were to sell the house. Now that one of the spouses has passed, that exclusion will revert back to $250,000 (single amount) within two years of the spouse passing.

In some situations, it may be a good idea to sell the house, enjoy the exclusion and buy another. This would be most advantageous if the gain on the house currently stands at more than $250,000 and the loss of the $500,000 exclusion would create a taxable event.

Finally, make sure that any life insurance or annuities are notified of the passing, and that the proceeds are processed out to the correct beneficiaries. In most cases, life insurance is not taxable to the beneficiary, so if a spouse has a $1,000,000 policy, and their surviving spouse gets a check for $1,000,000, that is not taxable.

Also, annuities can be tricky because the investment has a life insurance component (usually) and an investment component that is taxable. Understanding the contract, asking for a copy and examining the calculations to make sure reporting is correct should be a priority for accountants and estate attorneys.

Editor’s note: Be sure to check out Christopher Ragain’s earlier article in our series about life changes and tax, “8 Things You Need to Know About Divorce and Taxes.”