When preparing and filing personal income tax returns, it’s common to have deductions that exceed the amount you are allowed to take on the current year’s tax return. In those cases, you may be able to carry over those losses to apply against income earned in future years. But what happens if you die without having taken all the deductions you carried forward?
Here is a review of how some carryforward (or carryover) deductions are treated in the event of death:
Capital Loss Carryovers
Long term capital losses, which are losses on the sale of stock or other investment assets held for more than a year, can offset capital gains or up to $3,000 of ordinary income. If losses exceed these amounts, they can be carried forward to be taken in future years.
However, when you die, any capital loss carryover is lost. It cannot be utilized by your estate or surviving spouse except in the final tax return filed for the year that you die. Therefore, it’s important to use as much of the remaining deduction as possible in the final year (or in the years prior to death). There are planning techniques available to help accomplish this goal.
If you experience diminishing health over a period of years, you (or your power of attorney) can sell assets with a capital gain during your lifetime to ensure the carryover losses were used up. Your surviving spouse or estate can also sell assets with capital gains in the year you pass away and apply the carryover loss against those gains on the final tax return.
However, this technique works best when used by the surviving spouse and the final return is filed jointly. The estate is more limited in its use of this technique because once a person dies, there is a “step-up” (increase) in basis equal to the fair market value of the property at the time of death. If the estate sells the asset, there won’t be much capital gains generated because any increase in value during your lifetime won’t be taxed. The only capital gains that would be generated by the sale of estate assets would be if the asset appreciates in value between the time of death and when the asset is sold.
Net Operating Losses
These losses are generated by business activity and can be used to offset ordinary income. However, as with capital losses, they cannot be carried forward by the surviving spouse beyond the final tax return for the year of death unless the losses are directly tied to the surviving spouse’s involvement in the business activity. If the surviving spouse is tied to the business, he or she can still carry forward 50% of the losses into future years.
To maximize the use of the carryover losses in the final year, the surviving spouse can consider generating additional income to which the net operating loss can be applied on the final joint tax return. One option is for the surviving spouse to convert his or her standard IRA (in whole or in part) to a Roth IRA. This conversion creates taxable income for the survivor, but the net operating losses can offset this income to reduce the tax bill. An additional benefit of this approach is that once converted, the additional growth in the Roth IRA assets can be withdrawn tax-free.
The surviving spouse may also wish to defer other deductions to a subsequent year to increase the amount of net operating losses used in the final year before they are lost.
Donations to charities can generally be deducted up to 50% of income for the year. Excess contributions can be carried forward for the next 5 years. However, when one spouse passes away, the surviving spouse can only use the carryover amount on the final year’s return. Any amount left over is lost.
The surviving spouse has the option to generate additional income to use up the deduction, but it may not be that helpful because more income means higher taxes and not all of that can be offset because of the income limitation on charitable deductions.
There are other advanced planning techniques that can help reduce taxes. In order to take advantage of these opportunities, all members of the estate’s or surviving spouse’s team of advisors (financial advisor, CPA and attorney) need to work together and be in close contact to avoid potential loss of valuable tax deductions.
If you have an estate matter, contact us for a consultation.