If your spouse died in 2020, you are not alone. You will be among the many whose federal income tax situation is affected. Sad but true. Here are five important things to know at tax return time, which will be here all too soon.
You can file a joint return for 2020
Unless you remarried by 12/31/20, you were considered single for all of last year for federal income tax purposes. Even so, you’re still allowed to file a final joint Form 1040 with your deceased spouse for the 2020 tax year and thereby benefit from the more taxpayer-friendly rules for joint filers. That final joint return will include your deceased spouse’s income, deductions, and credits up to the time of death plus your income, deductions, and credits — as the surviving spouse — for the entire year.
You may be able to file as a tax-favored qualifying widow(er) for 2021 and 2022
If your spouse died in 2020, you may be able to file as a qualifying widow(er) for your 2021 and 2022 tax years. If so, you can continue to use the more-favorable federal income tax rate brackets for married joint-filing couples for those years. To be a qualifying widow(er), you must meet all of the following requirements:
- Your spouse died in 2020 and you are still unmarried at the end of the current year (2021 or 2022).
- You have a dependent child or stepchild for the current year, meaning you paid over half the child’s support for that year. For this purpose, the child’s dependent status is unaffected by his or her income for the year, and it doesn’t matter if the child is married and files a joint return with his or her spouse for the year.
- Said child lives in your home for all of the current year, except for temporary absences.
- You pay over half the cost of maintaining said home for the current year.
- You are not claimed as a dependent on another person’s return for the current year.
- You were entitled to file a joint return with your deceased spouse for 2020 —as explained earlier in item No. 1.
You get a tax basis step-up for inherited assets (hopefully)
If you inherited appreciated capital gain assets — such as securities or real estate — from your deceased spouse, current law allows you to increase the federal income tax basis of those assets to reflect their fair market value (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 spouse’s estate (probably you) makes that choice. When you sell an inherited asset that has received a basis step-up, you’ll only owe federal capital gains tax on post-death appreciation, if any.
- If you and your spouse owned one or more homes or other capital gain assets together, the tax basis of the ownership interest that belonged to your spouse (usually half) is stepped up to FMV as of the magic date.
- 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 appreciation that occurs after your spouse’s death.
Warning: This super-beneficial beneficial basis step-up break is on Joe Biden’s list for elimination, according to his pre-election tax plan. So, it could go bye-bye when the new Congress convenes. Hopefully not. Fingers crossed.
You get a bigger home sale gain exclusion (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, you as an unmarried surviving spouse are still allowed to claim the larger $500,000 joint-filer gain exclusion for a principal residence sale that occurs within two years after your spouse’s death. This is a beneficial rule, but pay attention to the deadline. Since the two-year period begins on the date of your spouse’s 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 any time during the calendar year after the year of your spouse’s death (that would be 2021 if your spouse died in 2020), you’ll automatically be within the two-year window.
You must follow the required minimum distribution (RMD) rules for inherited retirement accounts
If you inherited your deceased spouse’s IRA or qualified retirement plan account (like a 401(k) account), be aware that the so-called required minimum distribution (RMD) rules apply to inherited retirement account balances. Depending on your spouse’s age when he or she died and your own age, you may have to take an RMD this year — and pay the resulting extra income tax. You’ll usually get better RMD tax results if you choose to treat the inherited account as your own account. For details on the RMD rules for surviving spouses, see this previous Tax Guy.
Warning: You can’t afford to ignore the RMD 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 the Internal Revenue Code, and it can stack up year after year until you start getting things right. If you inherited one or more IRAs that amount to significant dollars, consider hiring a tax pro to get the best tax results under the RMD rules.