How to Calculate an IRS Estate Tax Deduction

The Internal Revenue Service estimates that less than 2 percent of estates will be subject to an estate tax. Why is that? Because, in addition to a Unified Credit (which we'll explain later), Uncle Sam allows for quite a few deductions that would decrease the net amount of the estate. Be sure you know if your estate is subject to such a tax.

Things You'll Need

• Calculator

Instructions

1. Know that estate taxes are not even applicable if one of the following conditions is true:

   1. The entire value of the deceased's estate is less than the Unified Credit, or exempted amount. In 2008, that amount is $2 million. In 2009, it increases to $3.5 million. So if the entire value of the estate is below those threshholds, deductions won't even be necessary to calculate.

   2. The entire estate is willed to a surviving spouse. Since the value of any estate gained by a surviving spouse is in itself a deduction, this situation would present an estate with a taxable value of $0.

2. Determine the value of the estate. This will include all assets of the deceased: any bank accounts with a positive balance, any life-insurance annuities, any real property (such as houses or vehicles), any deferred pensions or stock holdings, and any other annuities to which the deceased can lay claim, such as winnings from a lawsuit or lottery that were not paid out at the time of death. This total will give you the gross estate amount, from which deductions can be taken.

3. Subtract the Unified Credit explained in Step 1 from the gross estate amount. This will give you the initial net estate value. For example, if the deceased has real property of $1.5 million, a life insurance settlement of $1 million and deferred pensions equaling $500,000, the gross estate value would be $3 million. After deducting the Unified Credit of $2 million, the estate would then have an initial net value of $1 million.

4. Determine the amounts spent on a number of deductible items:

   1. Any funeral costs paid from the estate. Since most people hold life insurance to accommodate for this, and the life insurance is added to the estate value, one can then assume in most cases that these costs will be paid from the estate. In our hypothetical case, let's assume that the total costs of the funeral (burial plot, funeral home services, catering for a wake) amount to $10,000. In 2007, the average cost of a funeral service was $6,195.

   2. Any outstanding debts owed by the deceased. These include any remaining mortgages, loans or car payments. In our hypothetical case, let's assume the deceased still owed $600,000 on his mortgage, $50,000 on a college loan he took out for his children and $20,000 still left on a sailboat. These would amount to $670,000.

   3. Any fees paid to probate a will. The average cost to have an attorney write up and then execute an uncontested will is $2,000. Even if it should be contested and the legal fees rise, so too would the deduction rise.

   4. Any amount gifted to an authorized charity. The key word here is "authorized." There have been innumerable lawsuits over the years to determine if a charity was worthwhile enough to grant an heir a tax offset. Most good attorneys will know when drawing up a will if the charitable organization is indeed valid for a deduction. In our hypothetical case, let's say the deceased left $20,000 to his church and $20,000 to his alma mater.

   5. Any portion of the estate bequeathed to a surviving spouse. Should the deceased determine in his will that his spouse and children are to split the net value of his net estate equally, the amount left to his wife would be deductible (i.e., tax-free), while that left to his children would be subject to an estate tax.

   6. Any death or estate tax paid to a state, territory or foreign nation. This varies wildly from place to place, so we won't figure it into our hypothetical case.

5. Add the deductions detailed in Step 4. In our case, we have an estate with an initial net value of $1 million. After taking the deductions, the estate bequeathed to his children would have an adjusted net value of $139,000. This is the amount of a $3 million estate that would be taxed at 45 percent for the children of the deceased.

Tips & Warnings

• While the so-called death tax can penalize heirs after the estate holder dies, descendants can avoid a larger portion if the estate holder gifts certain percentages of the estate over a graduated time period. A licensed or certified estate planner can best calculate optimal tax offsets using this option.

• As is always the case in matters of such significance, it is always best to consult attorneys or certified estate planners for details more pertinent to your particular situation. Gathering life insurance for a lower amount to avoid estate taxes may seem smart now, but there are certain drawbacks and dangers. Again, an attorney or financial planner would best be able to determine the correct course for each person.