Interest accrued on U.S. Treasury bonds.   The interest accrued on U.S. Treasury bonds owned by a cash method taxpayer and redeemable for the payment of federal estate taxes that was not received as of the date of the individual's death is income in respect of the decedent. This interest is not included in the decedent's final income tax return. The estate will treat such interest as taxable income in the tax year received if it chooses to redeem the U.S. Treasury bonds to pay federal estate taxes. If the person entitled to the bonds (by bequest, devise, or inheritance, or because of the death of the individual) receives them, that person will treat the accrued interest as taxable income in the year the interest is received. Interest that accrues on the U.S. Treasury bonds after the owner's death does not represent income in respect of the decedent. The interest, however, is taxable income and must be included in the income of the respective recipients.

Interest accrued on savings certificates.   The interest accrued on savings certificates (redeemable after death without forfeiture of interest) that is for the period from the date of the last interest payment and ending with the date of the decedent's death, but not received as of that date, is income in respect of a decedent. Interest for a period after the decedent's death that becomes payable on the certificates after death is not income in respect of a decedent, but is taxable income includible in the income of the respective recipients.

Inherited IRAs.   If a beneficiary receives a lump-sum distribution from a traditional IRA he or she inherited, all or some of it may be taxable. The distribution is taxable in the year received as income in respect of a decedent up to the decedent's taxable balance. This is the decedent's balance at the time of death, including unrealized appreciation and income accrued to date of death, minus any basis (nondeductible contributions). Amounts distributed that are more than the decedent's entire IRA balance (includes taxable and nontaxable amounts) at the time of death are the income of the beneficiary.

If the beneficiary of a traditional IRA is the decedent's surviving spouse who properly rolls over the distribution into another traditional IRA, the distribution is not currently taxed. A surviving spouse also can roll over tax free the taxable part of the distribution into a qualified plan, section 403 annuity, or section 457 plan.

Example 1.   At the time of his death, Greg owned a traditional IRA. All of the contributions by Greg to the IRA had been deductible contributions. Greg's nephew, Mark, was the sole beneficiary of the IRA. The entire balance of the IRA, including income accruing before and after Greg's death, was distributed to Mark in a lump sum. Mark must include the total amount received in his income. The portion of the lump-sum distribution that equals the amount of the balance in the IRA at Greg's death, including the income earned before death, is income in respect of the decedent. Mark may take a deduction for any federal estate taxes that were paid on that portion.

Example 2.   Assume the same facts as in Example 1, except that some of Greg's contributions to the IRA had been nondeductible contributions. To determine the amount to include in income, Mark must subtract the total nondeductible contributions made by Greg from the total amount received (including the income that was earned in the IRA both before and after Greg's death). Income in respect of the decedent is the total amount included in income less the income earned after Greg's death.

For more information on inherited IRAs, see Publication 590.

Roth IRAs.   Qualified distributions from a Roth IRA are not subject to tax. A distribution made to a beneficiary or to the Roth IRA owner's estate on or after the date of death is a qualified distribution if it is made after the 5-tax-year period beginning with the first tax year in which a contribution was made to any Roth IRA of the owner.

A distribution cannot be a qualified distribution unless it is made after 2002.

Generally, the entire interest in the Roth IRA must be distributed by the end of the fifth calendar year after the year of the owner's death unless the interest is payable to a designated beneficiary over his or her life or life expectancy. If paid as an annuity, the distributions must begin before the end of the calendar year following the year of death. If the sole beneficiary is the decedent's spouse, the spouse can delay the distributions until the decedent would have reached age 70½ or can treat the Roth IRA as his or her own Roth IRA.

Part of any distribution to a beneficiary that is not a qualified distribution may be includible in the beneficiary's income. Generally, the part includible is the earnings in the Roth IRA. Earnings attributable to the period ending with the decedent's date of death are income in respect of the decedent. Additional earnings are the income of the beneficiary.

For more information on Roth IRAs, see Publication 590.

Coverdell education savings account (ESA).   Generally, the balance in a Coverdell ESA must be distributed within 30 days after the individual for whom the account was established reaches age 30 or dies, whichever is earlier. The treatment of the Coverdell ESA at the death of an individual under age 30 depends on who acquires the interest in the account. If the decedent's estate acquires the interest, see the discussion under Final Return for Decedent, earlier.

The age 30 limitation does not apply if the individual for whom the account was established or the beneficiary that acquires the account is an individual with special needs. This includes an individual who, because of a physical, mental, or emotional condition (including learning disability), requires additional time to complete his or her education.

If the decedent's spouse or other family member is the designated beneficiary of the decedent's account, the Coverdell ESA becomes that person's Coverdell ESA. It is subject to the rules discussed in Publication 970.

Any other beneficiary (including a spouse or family member who is not the designated beneficiary) must include in income the earnings portion of the distribution. Any balance remaining at the close of the 30-day period is deemed to be distributed at that time. The amount included in income is reduced by any qualified education expenses of the decedent that are paid by the beneficiary within 1 year after the decedent's date of death. An estate tax deduction, discussed later, applies to the amount included in income by a beneficiary other than the decedent's spouse or family member.

Archer MSA.   The treatment of an Archer MSA or a Medicare+Choice MSA, at the death of the account holder depends on who acquires the interest in the account. If the decedent's estate acquired the interest, see the discussion under Final Return for Decedent, earlier.

If the decedent's spouse is the designated beneficiary of the account, the account becomes that spouse's Archer MSA. It is subject to the rules discussed in Publication 969.

Any other beneficiary (including a spouse that is not the designated beneficiary) must include in income the fair market value of the assets in the account on the decedent's date of death. This amount must be reported for the beneficiary's tax year that includes the decedent's date of death. The amount included in income is reduced by any qualified medical expenses for the decedent that are paid by the beneficiary within 1 year after the decedent's date of death. An estate tax deduction, discussed later, applies to the amount included in income by a beneficiary other than the decedent's spouse.

Deductions in Respect of the Decedent

Items such as business expenses, income-producing expenses, interest, and taxes, for which the decedent was liable but that are not properly allowable as deductions on the decedent's final income tax return will be allowed as a deduction to one of the following when paid.

• The estate.
• The person who acquired an interest in the decedent's property (subject to such obligations) because of the decedent's death, if the estate was not liable for the obligation.

Similar treatment is given to the foreign tax credit. A beneficiary who must pay a foreign tax on income in respect of a decedent will be entitled to claim the foreign tax credit.

Depletion.   The deduction for percentage depletion is allowable only to the person (estate or beneficiary) who receives income in respect of the decedent to which the deduction relates, whether or not that person receives the property from which the income is derived. An heir who (because of the decedent's death) receives income as a result of the sale of units of mineral by the decedent (who used the cash method) will be entitled to the depletion allowance for that income. If the decedent had not figured the deduction on the basis of percentage depletion, any depletion deduction to which the decedent was entitled at the time of death would be allowable on the decedent's final return, and no depletion deduction in respect of the decedent would be allowed to anyone else.

For more information about depletion, see chapter 10 in Publication 535, Business Expenses.

Estate Tax Deduction

Income that a decedent had a right to receive is included in the decedent's gross estate and is subject to estate tax. This income in respect of a decedent is also taxed when received by the recipient (estate or beneficiary). However, an income tax deduction is allowed to the recipient for the estate tax paid on the income.

The deduction for estate tax can be claimed only for the same tax year in which the income in respect of the decedent must be included in the recipient's income. (This also is true for income in respect of a prior decedent.)

Individuals can claim this deduction only as an itemized deduction, on line 27 of Schedule A (Form 1040). This deduction is not subject to the 2% limit on miscellaneous itemized deductions. Estates can claim the deduction on the line provided for the deduction on Form 1041. For the alternative minimum tax computation, the deduction is not included in the itemized deductions that are an adjustment to taxable income.

If the income in respect of the decedent is capital gain income, you must reduce the gain, but not below zero, by any deduction for estate tax paid on such gain. This applies in figuring the following.

• The maximum tax on net capital gain.
• The 50% exclusion for gain on small business stock.
• The limitation on capital losses.

Computation

To figure a recipient's estate tax deduction, determine -

• The estate tax that qualifies for the deduction, and
• The recipient's part of the deductible tax.

Deductible estate tax.   The estate tax is the tax on the taxable estate, reduced by any credits allowed. The estate tax qualifying for the deduction is the part of the net value of all the items in the estate that represents income in respect of the decedent. Net value is the excess of the items of income in respect of the decedent over the items of expenses in respect of the decedent. The deductible estate tax is the difference between the actual estate tax and the estate tax determined without including net value.

Example 1.   Jack Sage used the cash method of accounting. At the time of his death, he was entitled to receive $12,000 from clients for his services and he had accrued bond interest of $8,000, for a total income in respect of the decedent of $20,000. He also owed $5,000 for business expenses for which his estate is liable. The income and expenses are reported on Jack's estate tax return.

The tax on Jack's estate is $9,460 after credits. The net value of the items included as income in respect of the decedent is $15,000 ($20,000 - $5,000). The estate tax determined without including the $15,000 in the taxable estate is $4,840, after credits. The estate tax that qualifies for the deduction is $4,620 ($9,460 - $4,840).

Recipient's deductible part.   Figure the recipient's part of the deductible estate tax by dividing the estate tax value of the items of income in respect of the decedent included in the recipient's income (the numerator) by the total value of all items included in the estate that represents income in respect of the decedent (the denominator). If the amount included in the recipient's income is less than the estate tax value of the item, use the lesser amount in the numerator.

Example 2.   As the beneficiary of Jack's estate (Example 1), you collect the $12,000 accounts receivable from his clients. You will include the $12,000 in your income in the tax year you receive it. If you itemize your deductions in that tax year, you can claim an estate tax deduction of $2,772 figured as follows:

Value included in your income	X	Estate tax qualifying for deduction
Total value of income in respect of decedent

	$12,000	X	$4,620	=	$2,772
	$20,000

If the amount you collected for the accounts receivable was more than $12,000, you would still claim $2,772 as an estate tax deduction because only the $12,000 actually reported on the estate tax return can be used in the above computation. However, if you collected less than the $12,000 reported on the estate tax return, use the smaller amount to figure the estate tax deduction.

Estates.   The estate tax deduction allowed an estate is figured in the same manner as just discussed. However, any income in respect of a decedent received by the estate during the tax year is reduced by any such income that is properly paid, credited, or required to be distributed by the estate to a beneficiary. The beneficiary would include such distributed income in respect of a decedent for figuring the beneficiary's deduction.

Surviving annuitants.   For the estate tax deduction, an annuity received by a surviving annuitant under a joint and survivor annuity contract is considered income in respect of a decedent. The deceased annuitant must have died after the annuity starting date. You must make a special computation to figure the estate tax deduction for the surviving annuitant. See section 1.691(d)-1 of the regulations.

Gifts, Insurance, and Inheritances

Property received as a gift, bequest, or inheritance is not included in your income. However, if property you receive in this manner later produces income, such as interest, dividends, or rents, that income is taxable to you. The income from property donated to a trust that is paid, credited, or distributed to you is taxable income to you. If the gift, bequest, or inheritance is the income from property, that income is taxable to you.

If you receive property from a decedent's estate in satisfaction of your right to the income of the estate, it is treated as a bequest or inheritance of income from property. See Distributions to Beneficiaries From an Estate, later.

Insurance

The proceeds from a decedent's life insurance policy paid by reason of his or her death generally are excluded from income. The exclusion applies to any beneficiary, whether a family member or other individual, a corporation, or a partnership.

Veterans' insurance proceeds.   Veterans' insurance proceeds and dividends are not taxable either to the veteran or to the beneficiaries.

Interest on dividends left on deposit with the Department of Veterans Affairs is not taxable.

Life insurance proceeds.   Life insurance proceeds paid to you because of the death of the insured (or because the insured is a member of the U.S. uniformed services who is missing in action) are not taxable unless the policy was turned over to you for a price. This is true even if the proceeds are paid under an accident or health insurance policy or an endowment contract. If the proceeds are received in installments, see the discussion under Insurance received in installments, later.

Accelerated death benefits.   You can exclude from income accelerated death benefits you receive on the life of an insured individual if certain requirements are met. Accelerated death benefits are amounts received under a life insurance contract before the death of the insured. These benefits also include amounts received on the sale or assignment of the contract to a viatical settlement provider. This exclusion applies only if the insured was a terminally ill individual or a chronically ill individual. This exclusion does not apply if the insured is a director, officer, employee, or has a financial interest, in any trade or business carried on by you.

Terminally ill individual.   A terminally ill individual is one who has been certified by a physician as having an illness or physical condition that reasonably can be expected to result in death in 24 months or less from the date of certification.

Chronically ill individual.   A chronically ill individual is one who has been certified as one of the following.

• An individual who, for at least 90 days, is unable to perform at least two activities of daily living without substantial assistance due to a loss of functional capacity.
• An individual who requires substantial supervision to be protected from threats to health and safety due to severe cognitive impairment.

A certification must have been made by a licensed health care practitioner within the previous 12 months.

Exclusion limited.   If the insured was a chronically ill individual, your exclusion of accelerated death benefits is limited to the cost you incurred in providing qualified long-term care services for the insured. In determining the cost incurred, do not include amounts paid or reimbursed by insurance or otherwise. Subject to certain limits, you can exclude payments received on a periodic basis without regard to your costs.

Insurance received in installments.   If you receive life insurance proceeds in installments, you can exclude part of each installment from your income.

To determine the part excluded, divide the amount held by the insurance company (generally the total lump sum payable at the death of the insured person) by the number of installments to be paid. Include anything over this excluded part in your income as interest.

Specified number of installments.   If you will receive a specified number of installments under the insurance contract, figure the part of each installment you can exclude by dividing the amount held by the insurance company by the number of installments to which you are entitled. A secondary beneficiary, in case you die before you receive all of the installments, is entitled to the same exclusion.

Example.   As beneficiary, you choose to receive $40,000 of life insurance proceeds in 10 annual installments of $6,000. Each year, you can exclude from your income $4,000 ($40,000 ÷ 10) as a return of principal. The balance of the installment, $2,000, is taxable as interest income.

Specified amount payable.   If each installment you receive under the insurance contract is a specific amount based on a guaranteed rate of interest, but the number of installments you will receive is uncertain, the part of each installment that you can exclude from income is the amount held by the insurance company divided by the number of installments necessary to use up the principal and guaranteed interest in the contract.

Example.   The face amount of the policy is $200,000, and as beneficiary you choose to receive annual installments of $12,000. The insurer's settlement option guarantees you this amount for 20 years based on a guaranteed rate of interest. It also provides that extra interest may be credited to the principal balance according to the insurer's earnings. The excludable part of each guaranteed installment is $10,000 ($200,000 ÷ 20 years). The balance of each guaranteed installment, $2,000, is interest income to you. The full amount of any additional payment for interest is income to you.

Installments for life.   If, as the beneficiary under an insurance contract, you are entitled to receive the proceeds in installments for the rest of your life without a refund or period-certain guarantee, you figure the excluded part of each installment by dividing the amount held by the insurance company by your life expectancy. If there is a refund or period-certain guarantee, the amount held by the insurance company for this purpose is reduced by the actuarial value of the guarantee.

Example.   As beneficiary, you choose to receive the $50,000 proceeds from a life insurance contract under a life-income- with-cash-refund option. You are guaranteed $2,700 a year for the rest of your life (which is estimated by use of mortality tables to be 25 years from the insured's death). The actuarial value of the refund feature is $9,000. The amount held by the insurance company, reduced by the value of the guarantee, is $41,000 ($50,000 - $9,000) and the excludable part of each installment representing a return of principal is $1,640 ($41,000 ÷ 25). The remaining $1,060 ($2,700 - $1,640) is interest income to you. If you should die before receiving the entire $50,000, the refund payable to the refund beneficiary is not taxable.

Interest option on insurance.   If an insurance company pays you interest only on proceeds from life insurance left on deposit, the interest you are paid is taxable.

Flexible premium contracts.   A life insurance contract (including any qualified additional benefits) is a flexible premium life insurance contract if it provides for the payment of one or more premiums that are not fixed by the insurer as to both timing and amount. For a flexible premium contract issued before January 1, 1985, the proceeds paid under the contract because of the death of the insured will be excluded from the recipient's income only if the contract meets the requirements explained under section 101(f) of the Internal Revenue Code.

Basis of Inherited Property

Your basis in property you inherit from a decedent is generally one of the following.

• The fair market value (FMV) of the property at the date of the individual's death.
• The FMV on the alternate valuation date (discussed in the instructions for Form 706), if so elected by the personal representative for the estate.
• The value under the special-use valuation method for real property used in farming or other closely held business (see Special-use valuation, later), if so elected by the personal representative.
• The decedent's adjusted basis in land to the extent of the value that is excluded from the decedent's taxable estate as a qualified conservation easement (discussed in the instructions for Form 706).

Exception for appreciated property.   If you or your spouse gave appreciated property to an individual during the 1-year period ending on the date of that individual's death and you (or your spouse) later acquired the same property from the decedent, your basis in the property is the same as the decedent's adjusted basis immediately before death.

Appreciated property.   Appreciated property is property that had an FMV greater than its adjusted basis on the day it was transferred to the decedent .

Special-use valuation.   If you are a qualified heir and you receive a farm or other closely held business real property from the estate for which the personal representative elected special-use valuation, the property is valued on the basis of its actual use rather than its FMV.

If you are a qualified heir and you buy special-use valuation property from the estate, your basis is the estate's basis (determined under the special-use valuation method) immediately before your purchase increased by any gain recognized by the estate.

You are a qualified heir if you are an ancestor (parent, grandparent, etc.), the spouse, or a lineal descendant (child, grandchild, etc.) of the decedent, a lineal descendant of the decedent's parent or spouse, or the spouse of any of these lineal descendants.

For more information on special-use valuation, see Form 706.

Increased basis for special-use valuation property.   Under certain conditions, some or all of the estate tax benefits obtained by using the special-use valuation will be subject to recapture. Generally, an additional estate tax must be paid by the qualified heir if within 10 years of the decedent's death the property is disposed of, or is no longer used for a qualifying purpose.

If you must pay any additional estate (recapture) tax, you can elect to increase your basis in the special-use valuation property to its FMV on the date of the decedent's death (or on the alternate valuation date, if it was elected by the personal representative). If you elect to increase your basis, you must pay interest on the recapture tax for the period from the date 9 months after the decedent's death until the date you pay the recapture tax.

For more information on the recapture tax, see Instructions for Form 706-A.

S corporation stock.   The basis of inherited S corporation stock must be reduced if there is income in respect of a decedent attributable to that stock.

Joint interest.   Figure the surviving tenant's new basis of property that was jointly owned (joint tenancy or tenancy by the entirety) by adding the surviving tenant's original basis in the property to the value of the part of the property (one of the values described earlier) included in the decedent's estate. Subtract from the sum any deductions for wear and tear, such as depreciation or depletion, allowed to the surviving tenant on that property.

Example.   Fred and Anne Maple (brother and sister) owned, as joint tenants with right of survivorship, rental property they purchased for $60,000. Anne paid $15,000 of the purchase price and Fred paid $45,000. Under local law, each had a half interest in the income from the property. When Fred died, the FMV of the property was $100,000. Depreciation deductions allowed before Fred's death were $20,000. Anne's basis in the property is $80,000 figured as follows:

Anne's original basis	$15,000
Interest acquired from Fred (¾ of $100,000)	75,000	$90,000
Minus: ½ of $20,000 depreciation		10,000
Anne's basis		$80,000

Qualified joint interest.   One-half of the value of property owned by a decedent and spouse as tenants by the entirety, or as joint tenants with right of survivorship if the decedent and spouse are the only joint tenants, is included in the decedent's gross estate. This is true regardless of how much each contributed toward the purchase price.

Figure the basis for a surviving spouse by adding one-half of the property's cost basis to the value included in the gross estate. Subtract from this sum any deductions for wear and tear, such as depreciation or depletion, allowed on that property to the surviving spouse.

Example.   Dan and Diane Gilbert owned, as tenants by the entirety, rental property they purchased for $60,000. Dan paid $15,000 of the purchase price and Diane paid $45,000. Under local law, each had a half interest in the income from the property. When Diane died, the FMV of the property was $100,000. Depreciation deductions allowed before Diane's death were $20,000. Dan's basis in the property is $70,000 figured as follows:

One-half of cost basis (½ of $60,000)	$30,000
Interest acquired from Diane (½ of $100,000)	50,000	$80,000
Minus: ½ of $20,000 depreciation		10,000
Dan's basis		$70,000

More information.   See Publication 551, Basis of Assets, for more information on basis. If you and your spouse lived in a community property state, see the discussion in that publication about figuring the basis of your community property after your spouse's death.

Depreciation.   If you can depreciate property you inherited, you generally must use the modified accelerated cost recovery system (MACRS) to determine depreciation.

For joint interests and qualified joint interests, you must make the following computations to figure depreciation.

• The first computation is for your original basis in the property.
• The second computation is for the inherited part of the property.

Continue depreciating your original basis under the same method you had used in previous years. Depreciate the inherited part using MACRS.

MACRS consists of two depreciation systems, the General Depreciation System (GDS) and the Alternative Depreciation System (ADS). For more information on MACRS, see Publication 946, How To Depreciate Property.

Substantial valuation misstatement.   If the value or adjusted basis of any property claimed on an income tax return is 200% or more of the amount determined to be the correct amount, there is a substantial valuation misstatement. If this misstatement results in an underpayment of tax of more than $5,000, an addition to tax of 20% of the underpayment can apply. The penalty increases to 40% if the value or adjusted basis is 400% or more of the amount determined to be the correct amount. If the value shown on the estate tax return is overstated and you use that value as your basis in the inherited property, you could be liable for the addition to tax.

The IRS may waive all or part of the addition to tax if you have a reasonable basis for the claimed value. The fact that the adjusted basis on your income tax return is the same as the value on the estate tax return is not enough to show that you had a reasonable basis to claim the valuation.

Holding period.   If you sell or dispose of inherited property that is a capital asset, you have a long-term gain or loss from property held for more than 1 year, regardless of how long you held the property.

Property distributed in kind.   Your basis in property distributed in kind by a decedent's estate is the same as the estate's basis immediately before the distribution plus any gain, or minus any loss, recognized by the estate. Property is distributed in kind if it satisfies your right to receive another property or amount, such as the income of the estate or a specific dollar amount. Property distributed in kind generally includes any noncash property you receive from the estate other than the following.

• A specific bequest (unless it must be distributed in more than three installments).
• Real property, the title to which passes directly to you under local law.

For information on an estate's recognized gain or loss on distributions in kind, see Income To Include under Income Tax Return of an Estate - Form 1041, later.

Previous | First | Next

Publication Index | 2002 Tax Help Archives | Tax Help Archives | Home