For the most part, inheritances are not subject to taxation. Inheritors do not have to report their bequests when they file their regular income tax returns, and appreciated assets get a step-up in basis for capital gains purposes. This means that an inheritor does not have to pay capital gains tax on appreciation that took place during the life of the decedent.
There is a federal estate tax that can be applicable, but there is an exclusion that can be used to transfer a certain amount of property tax-free. After the base exclusion has been set via legislative mandate, there are annual inflation adjustments.
Since we are reaching the end of 2020, the figure for 2021 has been released by the Internal Revenue Service. Before we provide that information, we will take a look at the road that has led to the record high exclusion that we will have during the 2021 calendar year.
The exclusion is set by Congress when tax legislation is passed, and the president has veto power. A robust exclusion is good for high net worth individuals, but people that think the wealthy should be heavily taxed adopt a different perspective.
This is reflected when you look at the way the estate tax exclusion has been treated over the last 20 years, and the rate is part of this equation as well. It was $675,000 with a 55 percent rate in 2001, and this was a remnant of the Clinton years.
Tax cuts were passed during the Bush administration, and the exclusion steadily went up as the rate went down. In 2009, the exclusion was $3.5 million, and the maximum rate was 45 percent.
The tax cuts culminated with a complete repeal of the estate tax for 2010, but the legislation was scheduled to expire or sunset at the end of that year. If there were no changes, the 2002 parameters ($1 million/50 percent) would have been reinstated.
At the end of December, lawmakers reached a compromise, and the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 was enacted. It mandated a $5 million exclusion and a 35 percent maximum rate in 2011 and 2012.
A fresh piece of tax legislation was passed two years later, and it retained the $5 million exclusion adjusted for inflation with an increase in the top rate to 40 percent.
This arrangement remained in place until 2018 when the Tax Cuts and Jobs Act of 2017 went into effect. The exclusion was doubled to a record high $11.18 million, and there was no change to the 40 percent rate. There have been inflation adjustments since 2018.
In 2020, the exclusion has been $11.58 million, and that is going up to $11.7 million in 2021, but there is an asterisk of sorts.
The aforementioned Tax Cuts and Jobs Act is going to sunset at the end of 2025. If no changes are made between now and then, the exclusion will go down to the $5.49 million that was in place in 2017 adjusted for inflation.
It is unlikely that the status quo will remain in place since there has been a shakeup in Washington, so this is an evolving situation that we will closely monitor. If there is any relevant news about a potential estate tax exclusion change, we will pass it along right here.
Federal Gift Tax
You would logically consider lifetime gift giving as a way to avoid the estate tax, but unfortunately, there is a federal gift tax as well. It is unified with the estate tax, so the exclusion that we have been looking at is a unified exclusion that applies to lifetime gifts and your estate.
However, there is an additional $15,000 per person, per year exclusion that you can use to give this much to any number of people annually free of taxation.
You would use a portion of your unified exclusion to give a tax-free gift if you give more than this much to any one person in a given calendar year.
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