Florida is one of only seven states with no state income tax. When combined with the warm climate, the friendly tax policy that allows for NO income taxes AND NO Florida estate and inheritance taxes makes Florida an immensely popular retirement destination. After all, if you’re a retiree on a fixed income, the tax savings on IRA distributions, Social Security benefits, and pension payments helps your budget go a little further. But, of course, as any Floridian can tell you, this doesn’t mean you don’t have to pay any income taxes. You just don’t pay state income taxes. The IRS still wants its money.
ESTATE AND INHERITANCE TAXES IN FLORIDA
Estate and inheritance taxes in Florida work essentially the same way. The state government doesn’t charge any “federal death tax,” but qualifying Florida estates are still responsible for estate taxes owed to the federal government. And Florida residents who inherit property from out-of-state may still have to pay inheritance taxes to the other state.
Defining Estate and Inheritance Taxes
Death taxes, including estate and inheritance taxes, are taxes imposed by a governing authority on the assets of a recently deceased person. The terms “estate tax” and “inheritance tax” are often used interchangeably – and they are similar – but there’s a subtle distinction between the two. Where an estate tax is owed by the estate itself, inheritance taxes are levied against the individual portions received by heirs. Estate taxes are paid by the estate executor, or Florida personal representative, using estate assets; inheritance taxes are owed by individual heirs, though it is not uncommon for Florida last wills to provide for payment of inheritance taxes from estate assets. Either way, the State of Florida does not impose any taxes on estates or inheritances, but other jurisdictions do.
Florida isn’t unique in this regard – only fourteen states have an estate tax, and four more have an inheritance tax (New Jersey and Maryland have both). But Florida does stand out in that estate taxes are expressly prohibited by the state constitution. So, for Florida to implement an estate tax would require a full-blown constitutional amendment and not just new legislation. This constitutional guaranty makes Florida’s tax laws particularly advantageous for anyone concerned about minimizing estate taxes.
If Florida is your primary state of residence, your future estate will be administered in Florida under Florida law, and it therefore won’t be subject to any inheritance taxes or state-level estate tax, regardless of where your heirs live. However, if you are a Florida resident and you inherit property from someone in a state that taxes inheritances, like for instance Pennsylvania, you may owe an inheritance tax to the other state. The amount of the tax and whether it is owed at all depends on the value of the inheritance, the taxing state’s rates and exemption scheme, and your familial relation to the deceased. Closer relations are typically allowed greater inheritance tax exemptions.
Distinguishing Inheritance Taxes vs. Income Taxes
It’s important to remember that inheritance taxes are completely distinct from income taxes, and inherited property is not taxable income due to the step up in basis. So, if you receive a large cash inheritance, you don’t have to include it as taxable income on your income tax return, even if you have to pay an inheritance tax. However, if you receive income derived from an inherited asset that would have been taxable to the decedent, then you are responsible for the income tax. For instance, if you withdraw money from an inherited IRA, and the distribution would have been taxable to the decedent, the funds you receive are taxable income. Or, if you sell inherited real estate for more than the deceased paid for it, you will likely have to pay either income or capital gains tax on the profit, depending on how long the property was held.
As mentioned above, the State of Florida doesn’t have a death tax, but qualifying Florida estates are still responsible for the federal estate tax (there is no federal inheritance tax). To the extent its assets exceed the $11.18 million exemption (as of 2018), an estate is taxed at a marginal rate of up to 40%. This means that, for an estate valued at $12 million, the $820,000 overage is subject to the tax, which is implemented in progressively increasing brackets like the federal income tax. Because transfers to spouses are exempt, married couples can effectively double the exemption to $22.36 million through the use of estate-planning strategies like pass-through trusts for spouses.
Calculating Taxable Estates
To calculate an estate’s taxable value, you simply subtract liabilities from assets, with “assets” defined broadly to include substantially more than what goes through probate. Real estate, financial accounts, business interests, assets held in a trust controlled by the decedent, and death benefits from life insurance policies are all included within a taxable estate. However, if a life insurance policy is held in an Irrevocable Life Insurance Trust (ILIT) for at least three years prior to death, the benefits can be kept out of the estate.
How Federal Estate Taxes Are Paid?
The federal tax is owed by the estate itself and must be paid by the executor in cash. This can cause problems for valuable estates with predominately illiquid assets like land. In some cases, executors are forced to liquidate assets to pay the taxes. A popular strategy for avoiding this dilemma is to take out a life insurance policy for estate planning, or more specifically where the death benefit is earmarked for payment of estate taxes and administrative fees.
Gifting Strategies and Irrevocable Trusts
To an extent, estate tax liability can be mitigated by removing assets from the future estate prior to death. This can be accomplished through certain forms of irrevocable trusts, or, more simply, by giving assets to heirs or charities during life. Selling off assets is generally not an effective strategy for reducing estate tax liability because the value is just transferred from one form to another.
The tax code allows annual gifts of up to $15,000 per recipient (doubled for married couples) without any gift tax liability. So, if you give assets worth $15,000 to each of your three kids, you will have reduced your eventual estate by $45,000 without incurring any gift tax for yourself or your children. Repeat the gifts over a few years, and future estate tax liability can be dramatically reduced or even eliminated.
The gifting strategy is particularly effective with appreciating assets because the recipient acquires the giver’s tax basis along with the gifted asset. When the recipient eventually transfers the asset, he or she will owe capital gains tax on the appreciation at a maximum rate of 20.00%. On the other hand, if the asset remains in the estate (and the estate qualifies for the tax), it will be subject to the estate tax at a maximum rate of 40.00% of the asset’s present value, with no reduction for the cost basis.
Gifts of over $15,000 to one recipient within a single year require a Form 709 gift tax return. There won’t necessarily be any gift tax due at the time, but the value of the gift over $15,000 is deducted from the giver’s $11.18 million lifetime limit, which is tied to the estate tax exemption. For instance, if you give away an asset worth $205,000 ($180,000 over the yearly maximum), your eventual estate tax exemption will be reduced from $11.18 million to $11 million. The lifetime gift exemption is just that – a lifetime maximum. Once you use it up, you can’t get it back, so it’s a good idea to gift strategically.
Gifts from one spouse to the other and gifts for educational or medical expenses (as long as paid directly to the provider and not to the person receiving the benefit) are not subject to the gift tax. Hence, if you give your grandson $50,000 to pay for college, your exemption will be reduced by $35,000 – the amount of the gift minus the $15,000 allowed annually. But, if you pay the school directly, your exemption won’t be affected.
Due to its estate, inheritance, and income tax policies, Florida is generally considered a tax-friendly state for retirees. And although Florida’s laws can’t protect residents from federal estate taxes or inheritance taxes imposed by other states, a strategic approach developed with the help of an experienced Florida estate-planning attorney can go a long way toward reducing tax liability and ensuring that you transfer more of your estate to your loved ones and less to the IRS.
Steve Gibbs, Esq.