Karen Snodgrass

CPA | CK Principal

The death of a spouse is a profoundly challenging time, both emotionally and financially. Amidst the grieving process, surviving spouses must also navigate a complex array of tax issues. Understanding these tax implications is crucial to ensuring compliance and optimizing financial outcomes. This article explores the key tax considerations for surviving spouses, including filing status, inherited basis adjustments, home sale exclusions, notifications to relevant agencies, estate tax considerations, and trust issues.

Identify and Communicate with Key Advisors

If you have a team of trusted advisors – accountants, attorneys, insurance, and/or financial professionals – these individuals are adept at advising clients during this trying time. They have experience in dealing with these difficult issues and can advise in a non-partial way.  Let them help you as you grieve your loss.

Ideally, determining the key advisors should not be a difficult process. In some cases, prepared individuals may have created a crash card to assist their families upon their passing. The crash card may help you identify advisors and to know where important documents are stored.

Notifications to Social Security Administration and Payers of Pensions

It is imperative for the surviving spouse to notify the Social Security Administration (SSA) of the spouse’s death to adjust benefits accordingly. Usually, the funeral home will notify SSA, but to be safe, the surviving spouse should also contact SSA. Similarly, any payers of pensions or retirement plans must be informed to ensure the proper distribution of benefits and to avoid potential overpayments that would have to be repaid.

Changing Titles

To prevent future complications, it is essential to change the title of jointly held assets to the survivor’s name alone. This includes real estate, vehicles, and financial accounts. It is also an opportunity to determine whether ownership should be held individually or in trust. Properly updating titles ensures clear ownership and facilitates future transactions.

Beneficiary Designations

Surviving spouses should also review and update their own beneficiary designations on life insurance policies, retirement accounts, and wills.

Living Trusts and Other Trusts

Many couples establish living trusts to manage their assets. Upon the death of one spouse, the trust may split into two separate trusts: one revocable and one irrevocable. The irrevocable trust typically requires a separate tax return. Understanding the terms of the trust and its tax implications is crucial for compliance and effective estate planning.

Filing Status in the Year of Death

In the year of a spouse’s death, and provided the surviving spouse has not remarried, the surviving spouse has several filing status options. The option most often used is to file a joint tax return with the deceased spouse. This option is generally more favorable than filing as a single individual, as it allows for higher income thresholds and deductions. If the surviving spouse chooses not to file jointly, they may file as married filing separately or, if they qualify, as head of household.

If the surviving spouse has not remarried and has a dependent child, they may qualify as a “Qualifying Surviving Spouse” for up to two years after the year of the spouse’s death. This status offers benefits similar to those of filing jointly.

Inherited Basis Adjustments

When a spouse passes away, the surviving spouse may receive an adjustment in basis for the inherited assets, which can significantly affect future capital gains taxes. The extent of this basis adjustment depends on how the title to the assets was held:

1. Sole Ownership by the Deceased Spouse: If the deceased spouse solely owned an asset, the surviving spouse typically receives a full step-up in basis. This means the asset’s basis is adjusted to its fair market value on the date of the deceased spouse’s death. This adjustment can reduce or eliminate capital gains taxes if the asset is sold shortly after the spouse’s death.
2. Joint Tenancy with Right of Survivorship: In cases where the asset was held in joint tenancy with right of survivorship, the surviving spouse generally receives a step-up in basis for the deceased spouse’s share of the asset. For example, if a home was jointly owned, the basis of the deceased spouse’s half is stepped up to its fair market value at the spouse’s time of death, while the surviving spouse’s half retains its original basis.
3. Community Property States: In community property states, both halves of community property receive a step-up in basis upon the death of one spouse, regardless of which spouse’s name is on the title. This means the entire property is adjusted to its fair market value at the time of death, providing a significant tax advantage for the surviving spouse.
4. Tenancy by the Entirety: Like joint tenancy, in states that recognize tenancy by the entirety, the surviving spouse receives a step-up in basis for the deceased spouse’s share of the property.

The rationale behind these basis adjustments is to align the tax basis of inherited assets with their current market value, thereby reducing the potential capital gains tax burden on the surviving spouse. This adjustment reflects the change in ownership and the economic reality that the surviving spouse is now the sole owner of the asset.  

Establishing Inherited Basis

To establish the inherited basis, obtaining a qualified appraisal of the assets as of the date of death is often necessary. This appraisal serves as documentation for the basis and is crucial for accurately calculating capital gains or losses upon the future sale of the assets.

Future Home Sale and Gain Exclusion

Surviving spouses may benefit from the home gain exclusion, which allows for the exclusion of up to $500,000 of gain from the sale of a primary residence, provided the sale occurs within two years of the spouse’s death, and the requirements for the exclusion were met prior to the death. This exclusion can be a valuable tool for minimizing taxes on the sale of a home, although in most cases, any gain within the two years is likely to be minimal because of the basis step-up provision. After the two-year period has elapsed, the exclusion drops to $250,000.

Estate Tax Considerations and Portability Election

If the deceased spouse’s estate exceeds the federal estate tax exemption, an estate tax return may be required. Even if the estate is below the exemption threshold, filing an estate tax return can be beneficial to elect portability. Portability allows the surviving spouse to utilize the deceased spouse’s unused estate tax exemption, potentially reducing estate taxes upon the surviving spouse’s death. Not only federal estate tax laws should be considered, but state estate tax laws as well.

Understanding the Treatment of Tax Attributes for Surviving Spouses

In addition to the primary tax considerations, surviving spouses must also be aware of how tax attributes are treated following the death of a spouse. Tax attributes include various tax-related characteristics such as net operating losses, capital loss carryovers, and passive activity losses. This can be complicated based on whether the attributes are related to a specific spouse or jointly.

The tax issues facing surviving spouses are multifaceted and require careful consideration. By understanding filing status options, inherited basis adjustments, home sale exclusions, and other critical tax matters, surviving spouses can navigate this challenging period with greater confidence and financial security.

Contact CK’s office at 630.953.4900 for professional tax assistance to ensure compliance and optimize financial outcomes during this difficult time. Our trusted team of advisors will be there to guide you every step of the way.