Most Americans do not have to worry about the estate tax because the first $5 million of property is exempt as of 2012. However, if you have a large estate, live in a state or locality with an inheritance tax, or if the federal government reduces or eliminates the estate tax exemption in the future, you may want to know how your estate is calculated and how much may be subject to the estate tax.
Everything You Own
Your gross estate includes everything you own at the time of your death, whether or not these assets pass through a will or have been designated to a beneficiary. For example, your home, car and other physical property are included in your estate and are distributed either by will or through intestate succession if you do not have a will. Bank accounts, retirement accounts and pensions are part of your gross estate as well, even if these assets pass directly to a named beneficiary.
The Internal Revenue Service values all of your assets at fair market value at the time of your death to calculate your gross estate. Fair market value is the price that "property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts." For example, if you purchased a tract of land 15 years ago for $100,000 and it is now worth $200,000, the value of the land is $200,000 for purposes of the estate tax. This means that the assets in your estate may be worth more than you paid for them, and your beneficiaries will assume the fair market value rather than your basis. Continuing the land example, if you sold the land for $250,000, you would have had a gain of $150,000. However, when your beneficiary inherits the $200,000 basis, he only has to recognize $50,000 of gain.
Reducing Your Estate Value
When the estate tax is calculated, the value of your estate is reduced by several exclusions. First, any portion of the gift tax exclusion that you did not use during your life to avoid taxes on gifts is applied. For example, if you claimed the exemption on $1 million in gifts during your life, and you have a $5 million gift tax exemption, you have $4 million of the exemption remaining. Second, any property transferred directly to your spouse is excluded as long as it is transferred outright. Third, property left to charity or used to pay off your mortgage and other debt is deducted from your gross estate. Finally, administrative expenses of managing the estate and losses incurred during the administration of the estate are deducted.
Estate Tax Returns
Your estate must file an estate tax return if the gross value of the estate exceeds your exemption from the estate tax. As of 2012, the exemption is $5 million minus any portion of the exemption used during your life to avoid gift taxes. You should also file an estate tax return if you want to preserve the unused portion of the estate tax exemption for your spouse. For example, if you never used any of your exemption on gifts you gave to others, and your gross estate is only worth $4 million, you would not be required to file an estate tax return; but if you wanted to preserve the remaining $1 million for your spouse, so that her exemption would be $6 million, your estate must file an estate tax return.