Estate taxes are taxes that the government charges on the money and property that someone leaves behind when they die. The amount of tax depends on the estate’s worth; however, there are often ways to reduce the tax through advanced planning strategies.
This post aims to demystify estate taxes, focusing on their application both federally and within Colorado. We hope you’ll gain insight into what estate taxes are, how they differ from inheritance taxes, and strategies to reduce your estate tax liability by reading this.
Table of Contents
- 1 What Is An Estate Tax?
- 2 Does Colorado Have An Estate Tax?
- 3 What’s The Difference Between An Estate Tax And An Inheritance Tax?
- 4 Does Colorado Have An Inheritance Tax?
- 5 What Happens When You Inherit A House In Colorado?
- 6 Strategies To Lower Your Estate Tax Liability
- 7 Let Us Help You With Your Tax Planning In Colorado
What Is An Estate Tax?
An estate tax is imposed on the entire value of a deceased individual’s assets prior to their distribution to heirs. The main purposes of this tax are to generate revenue for the government and mitigate wealth concentration.
Estate taxes are calculated by assessing the fair market value of all owned assets, including properties, investments, cash, and personal belongings. From this total, any debts, mortgages, and funeral expenses are deducted to derive the net value of the estate. The resulting value is then subjected to tax rates, which can differ at the federal level and between states.
An estate encompasses assets such as real estate, stocks, bonds, business interests, retirement funds, and valuable personal items like art and jewelry. For example, an estate might include a family home, investment properties, shares in local businesses, and various personal investments.
At the federal level, estate tax thresholds and rates can change according to legislation. Currently, estates below a threshold (set at $13.61 million for an individual and $27.24 million for a couple) might not incur federal estate taxes.1 However, estates that exceed this threshold can face substantial tax rates, beginning at 18% and going as high as 40% for very large estates.2 Staying updated on these thresholds is important for effective planning.
Please Note: The federal estate tax exemption is expected to decrease significantly. Unless current laws are extended by Congress, in 2026, the exemption will revert to $5 million, adjusted for inflation.3
Does Colorado Have An Estate Tax?
Colorado does not impose an estate tax at the state level. This means Colorado residents are exempt from state estate taxes but must still account for federal tax obligations during estate planning.
Previously, Colorado had a “pick-up” tax, which allowed the state to collect a portion of the federal estate tax. This tax was effectively eliminated in 2005 when the federal government phased out the state death tax credit.4 Since then, Colorado has not reinstated a state-level estate tax, aligning with several other states that do not have an additional estate tax. However, a few states do impose their estate taxes.
The states that have their estate tax include:
- Rhode Island
- Vermont
- Washington
- Hawaii
- Illinois
- Connecticut
- Minnesota
- Maryland
- Maine
- Massachusetts
- Oregon
- New York
Please Note: The District of Columbia also imposes estate taxes. Additionally, the estate tax rates for D.C. and the twelve states above vary widely.5
What’s The Difference Between An Estate Tax And An Inheritance Tax?
Inheritance tax is a charge imposed on assets received from a deceased individual’s estate. It differs from estate tax, which is calculated on the entire estate’s value prior to distribution. Inheritance tax, however, is settled by the beneficiaries who receive the assets. The rate is influenced by the worth of the inheritance and the heir’s relationship to the person who has passed away.
The primary point of difference between an estate tax and an inheritance tax lies in who pays them. Unlike estate taxes, which are paid from the estate’s funds before any distribution, inheritance taxes are the beneficiaries’ responsibility. Estate taxes are based on the entire value of the deceased’s estate, while inheritance taxes are calculated on the amount each heir inherits.
Proper planning can reduce the tax burden on both the estate and the heirs, preserving more assets for future generations.
Does Colorado Have An Inheritance Tax?
Colorado does not currently impose an inheritance tax on assets received from a deceased individual’s estate. However, federal estate taxes might still apply if the estate’s overall value exceeds federal thresholds.
Unlike Colorado, some states do impose their own inheritance taxes. These taxes vary in terms of rates and thresholds, impacting how much beneficiaries need to pay.
The states that have their own inheritance tax include:6
- New Jersey
- Pennsylvania
- Iowa
- Kentucky
- Maryland
- Nebraska
Please Note: Following its repeal in 2021, Iowa is phasing out its inheritance tax. Between 2021 and 2024, some beneficiaries will still need to pay a reduced inheritance tax on estates during this transitional period.6
What Happens When You Inherit A House In Colorado?
Inheriting a house in Colorado can be both a blessing and a challenge. This significant event brings with it a mix of emotions and responsibilities. Whether you’re planning to keep, sell, or rent out the property, knowing what to expect can help you navigate the process more smoothly.
Steps to Take After Inheriting a House in Colorado
Inheriting a house requires several steps to create a more seamless transition and maintain compliance with legal and financial obligations. Properly managing these steps can help avoid complications and maximize the value of your inheritance. Here’s what you need to do:
Coordinate with the Executor and Any Other Heirs: Begin by reaching out to the executor to understand the details of the inheritance process. Identify any co-heirs and initiate discussions about the future of the property. It’s important to understand everyone’s preferences—whether they intend to keep, sell, or live in the house. Open communication early on can help avoid conflicts. If disputes arise, consider seeking professional mediation.
Assess Outstanding Debts and Liens: Check for any debts or liens against the property. This includes mortgages, tax liens, and other claims. Understanding these financial obligations is necessary for evaluating the house’s overall value and making the best decision about what to do with the property.
Arrange for a Property Appraisal: If the executor hasn’t done this already, it’s wise to get an appraisal of the property. Knowing the house’s market value is essential for making informed decisions about keeping, selling, or renting it out. Additionally, the appraisal will help you understand any potential tax obligations.
Get Professional Help: Engage with legal and financial advisors to handle the complexities of inheritance. Their assistance can help you meet all requirements and make better-quality decisions.
Potential Costs and Taxes Involved
Inheriting a house can come with various costs, such as ongoing property taxes, maintenance expenses, and any existing mortgages. However, before considering selling the property, it’s important to understand how the property’s value is assessed for tax purposes.
When you inherit real estate, the property’s basis is typically “stepped up.” This means the property’s value is adjusted to its fair market value at the time of the original owner’s passing. This adjustment can be highly beneficial if you choose to sell the property, as the stepped-up basis can lower or even eliminate your capital gains tax liability.7
For example, if you inherit a house that was originally purchased for $400,000 but is worth $600,000 at the time of inheritance, the stepped-up basis would be $600,000. If you sell the property immediately for $600,000, you wouldn’t owe any capital gains taxes because there is no appreciation beyond the stepped-up basis. Similarly, if the house were sold at a depreciated value, say $550,000, there would still be no capital gains tax (even though it’s above the original purchase price).
On the other hand, if you keep the property and its value increases over time, say to $750,000, you would owe capital gains taxes when you sell it. The tax would be based on the $150,000 increase in value beyond the stepped-up basis.
Please Note: In Colorado, capital gains taxes max out at 4.4%.8 At the Federal level, capital gains taxes vary between 0% to 37% for short-term capital gains and 0% to 20% for long-term capital gains, depending on your income.9 For those with higher incomes, the Net Investment Income Tax (NIIT) may also apply, adding an additional 3.8% tax on investment income, including gains from the sale of inherited property. This tax can also affect trusts and estates with incomes that exceed IRS thresholds.10
Options for Managing Inherited Property (Keeping, Selling, Renting)
After inheriting a house, you have several options: you can keep it as a personal residence, sell it to unlock its cash value or rent it out for additional income. Each choice has different financial and tax implications, so consider your circumstances and consult a financial advisor to make the best decision.
Strategies To Lower Your Estate Tax Liability
Strategic planning can significantly decrease the taxes owed on your estate, preserving more wealth for your heirs. Here are some strategies to consider:
Gifting Assets and Annual Exclusion Limits: This is a powerful way of giving away assets during your lifetime. The annual gift tax exclusion lets you transfer a certain amount to each recipient annually without triggering gift taxes. This reduces your estate’s overall value, lowering potential estate taxes.
Establishing Trusts for Tax Reduction: Creating trusts is a highly effective way to handle and reduce estate taxes. Irrevocable trusts, in particular, can exclude assets from your taxable estate, ensuring they aren’t subject to estate taxes when you pass away. Trusts also provide control over the distribution of your assets to beneficiaries.
Impact of Charitable Contributions on Estate Taxes: Donating to charities can reduce your estate taxes. Contributions made either during your lifetime or as part of your estate plan lower the taxable value of your estate, as these donations are generally exempt from estate taxes.
Additional Estate Planning Techniques: Other tools include family limited partnerships (FLPs) and life insurance policies. FLPs enable asset transfers to family members while you retain control, often at a reduced value. Life insurance can supply the essential funds to pay estate taxes, thereby safeguarding the remaining estate assets. Using a combination of these strategies can substantially cut your estate tax liability.
Please Note: These are just high-level strategies. Individual circumstances will ultimately determine the best approach. For example, direct payments for education or medical expenses or setting up a donor-advised fund might be suitable for your situation. Collaborating with an estate planning professional and a financial advisor is essential to developing a plan tailored to your specific needs and objectives.
Let Us Help You With Your Tax Planning In Colorado
At Colorado Capital Management, we understand that estate taxes can be a challenging aspect of your financial planning. We can work closely with your estate planning attorney to simplify this complex topic and provide you with effective strategies to manage your estate, potentially helping you reduce your tax obligations and pass on maximum value to your heirs.
Proper estate planning is important to protecting your wealth and ensuring a smooth transition for your loved ones. Whether you’re looking to gift assets during your lifetime, set up trusts, or make charitable donations, these steps can significantly impact your estate’s value and tax liabilities.
In addition to tax reduction, we offer comprehensive advice on various estate planning techniques tailored to your situation. This might include direct payments for education or medical expenses and creating donor-advised funds. These approaches may lessen your tax burden and support your broader financial and charitable goals.
You don’t have to tackle estate taxes alone. Our dedicated team of experts is here to guide you through the process, partner with your estate planning professional and help provide the support you need to secure your financial legacy. Schedule a consultation and take the first step toward ensuring a well-planned future for you and your family.
Sources:
- https://www.irs.gov/businesses/small-businesses-self-employed/estate-tax
- https://www.cnbc.com/select/what-is-estate-tax-and-who-pays-it/#:~:text=Yes%2C%20there%20is%20a%20federal,pay%20taxes%20on%20%241%20million
- https://www.irs.gov/newsroom/estate-and-gift-tax-faqs
- https://leg.colorado.gov/agencies/legislative-council-staff/estate-tax
- https://www.taxpolicycenter.org/briefing-book/how-do-state-and-local-estate-and-inheritance-taxes-work
- https://www.nolo.com/legal-encyclopedia/state-inheritance-taxes.html
- https://www.investopedia.com/terms/s/stepupinbasis.asp
- https://www.fool.com/research/capital-gains-tax-rates/
- https://www.fidelity.com/learning-center/smart-money/capital-gains-tax-rates
- https://www.irs.gov/newsroom/questions-and-answers-on-the-net-investment-income-tax#:~:text=Basics%20of%20the%20Net%20Investment%20Income%20Tax&text=The%20Net%20Investment%20Income%20Tax%20is%20imposed%20by%20section%201411,above%20the%20statutory%20threshold%20amounts
An entrepreneur and world traveler, Colorado Capital Management vice president and co-owner Lee Strongwater brings a global perspective to investments and life planning.
Editor’s Note: This blog post is for informational purposes only and does not constitute financial, legal, or tax advice. Readers are encouraged to consult with a qualified professional regarding their individual circumstances. Please refer to our firm’s website for full disclosures and important information: CCM Website Disclaimer