What Properties Are Exempt From the Federal Estate Tax?

The federal estate tax is a tax that people often have to pay on property they inherit from someone who’s deceased. While this tax applies to most types of property, a few circumstances and property types are exempt from the federal estate tax. Knowing which types of property are exempt from Estate Tax can help you with financial planning, especially if you’ve recently inherited a piece of property you’re not sure you have to pay taxes on. Here’s more information about which properties are exempt from the federal state tax.

Key Takeaways

• While the federal estate tax applies to most property inherited from a deceased person, multiple types of property are exempt from the tax.
• Exemptions such as marital deduction and charitable deduction allow someone to inherit property and other assets without paying the federal estate tax, as long as the inheritance follows specific stipulations.
• Each type of federal estate tax exemption involves stipulations that determine whether an asset qualifies, such as ensuring a life insurance payout is taken in a lump sum or that the owner of a family-owned business was a United States citizen or resident.
• A family residence can transfer to a direct descendant without causing them to pay federal estate tax because it falls under the homeowner exemption that waives taxes for people who own and live in a piece of property.
• Gifts sometimes incur a gift tax, but people can avoid paying this by ensuring their gifts remain under the value threshold for the federal annual exclusion.

Marital Deduction

The marital deduction is a tax exemption for married couples when one spouse passes away before the other. It stipulates that in the case of death, there’s no limit to the amount of gifts or property that can be transferred to the living spouse. This means that if someone inherits a piece of property from their spouse, they won’t have to pay the federal estate tax that usually applies to this type of property transfer. It’s important to stipulate the inheritance clearly in a will to ensure the surviving spouse can take advantage of these benefits.

However, this deduction doesn’t completely wipe away all the tax costs. When the surviving spouse dies, the deferred estate tax will pass on to the person who inherits the property. While a tax will still be paid eventually, the marital deduction allows the living spouse to use the property and any other funds they inherit for their whole life, which can be a huge help for financial planning.

Charitable Deduction

A charitable deduction applies to gifts and donations a person makes before dying. This means that when someone bequeaths property to someone through a charitable donation before passing away, the recipient won’t have to pay federal estate tax on that property. However, a few stipulations accompany the charitable deduction that are important to keep in mind. For example, the assets being passed on have to come directly from the deceased person while they were alive. If the donation occurs after death, the recipient may qualify for a tax debt deduction instead of a charitable deduction.

Another stipulation that surrounds charitable deductions is asset type. Charitable deductions only apply to gross estate assets, which are assets included in the deceased person’s income, such as property or appreciated stock. For example, some trusts don’t qualify as charitable deductions when they’re not included in someone’s gross estate. As long as your assets fall into the right class and follow the rules of donation, there’s no limit to how much someone can inherit as a charitable deduction.

Family Residences

When a person leaves a family residence to their direct descendants when they pass away, the recipients won’t typically need to pay federal estate tax. This is because family residencies fall under homeowner exemptions that save people from paying taxes on a home when they own and occupy it as their primary residence. As long as the recipient plans to live in the home and maintain it as their own property, they can take advantage of the exemption. If they choose to sell the property, they’ll often need to pay income tax on the money they receive from the sale.

Each state also has rules about the exact deference and exemptions that various types of property receive, including family residences, so it’s important to review the specific exemptions your state offers. For example, in Illinois, people can receive additional tax breaks when their property qualifies as a homestead or if the homeowner is a military veteran.

Life Insurance Proceeds

Some life insurance payouts require you to pay taxes on them, such as when you opt to take the policy’s cash value, sell the policy to a third party, or give up the policy to the initial insurer. However, many types of life insurance payouts are exempt from the federal estate tax. For example, if the deceased doesn’t hold any incidents of ownership in the policy, the beneficiary won’t need to pay federal estate tax on the money they receive. 

There are two types of life insurance that can have different tax rules: term life insurance and whole life insurance. With term life insurance, the beneficiary won’t have to pay taxes on the money they inherit as long as they take it as a lump sum. They may have to pay taxes on the interest if it’s an annuity account. When receiving benefits from a whole life insurance policy, people don’t usually have to pay taxes on the death benefit they get. The exception is if they choose to receive their payout in monthly installments.

Qualified Family-Owned Business Interests

If a person owns a business before they pass away, they can save the people they leave their company to from paying federal estate taxes on that business. There are three conditions for receiving this exemption, including verification that the deceased person was a U.S. citizen or resident at the time of their death. The value of the business must also exceed at least 35% of their adjusted gross estate. The final condition for a family-owned business exemption is that the estate’s executor needs to make a Sec. 6166 election on their federal estate tax return.

A family-owned business that qualifies for this type of exemption is known as a closely held business. This means that the business owners are heavily involved in the operations that the business completes and the trading of stock in the company. To qualify for the tax exemption, the closely held business must also be in operation or conducting active trades at the time of death of the deceased. So, if a company hasn’t been conducting business for a while, it won’t qualify for the exemption, even if it’s still in the deceased person’s name and will.

One important detail about family-owned business exemptions is that they only apply to the closely held business. For example, if your business accounts for 70% of your overall gross estate, the people who inherit your business will still have to pay estate tax on the remaining 30%, even if the business is exempt. 

Gifts

The annual gift exclusion is a tax deduction that stipulates how much money someone can give to someone else as a gift without having to pay a gift tax. In 2022, the federal annual exclusion amount was $16,000, which increased to $17,000 in 2023. When a person leaves an inheritance or transfers money as a gift before their death, they can save the recipient from paying an estate tax by ensuring the amount remains within this threshold. Even if the amount decreases in the future, any gifts given before the threshold falls are still protected from the gift tax.

Some gifts receive tax exemptions automatically. For example, if the gift is valued at less than the person’s annual exclusion amount, it won’t be taxable. Gifts to a spouse or a political organization are also exempt from taxes in every case. Other exemptions include monetary gifts used for tuition or urgent medical expenses. If you make charitable donations, you can also deduct these from the value you’ll need to pay taxes on, as they typically fall under the charitable deduction and annual gift exclusion.

These are a few types of property that most commonly qualify for exemptions from the federal estate tax. If you’ve recently inherited assets or property, research the tax exemptions in your state so you can determine exactly how much you need to pay. When your inheritance falls under one of these types of property, you’ll likely be able to qualify for exemptions that save you from paying thousands of dollars in taxes, which can aid your financial planning for years to come.