Family Member Death and Medical Expenses

Background
For federal income tax purposes, deductions for a taxpayer’s unreimbursed medical expenses are only allowed for the tax year in which the expenses are actually paid. But what happens when someone incurs significant medical expenses and then dies before payment occurs?

Good question. Please keep reading.
Election Allows Income Tax Deduction for Unpaid Medical Expenses. The executor of the decedent’s estate (called the personal representative in IRS lingo) can elect, for federal income tax purposes, to treat all or a portion of medical expenses that are paid out of the estate during the one-year period that begins on the day after the date of death as if they were paid at the time they were incurred. In other words, the election allows a deduction as if the expenses were paid when the related medical services were rendered.  Therefore, making the election usually allows medical expenses paid within one year after death to be deducted on the decedent’s final Form 1040. As illustrated by Example 1 later in this release, making the election may also allow deductions on Form 1040 for an earlier year.

Final Medical Expense Deduction Basics.

Under the current rules, medical expenses can be written off as a Schedule A itemized deduction only to the extent they exceed 10% of AGI. While the percent-of- AGI threshold are an impediment to claiming deductions, final medical expenses are often big enough to easily surpass the applicable threshold. Note that the election to accelerate the income tax deduction for medical expenses that are unpaid on the date of death is only allowed for expenses that are later paid by the estate within one year after death. So this is not a something-for-nothing deal.

Final Form 1040 Basics.

A calendar-year decedent’s final Form 1040 covers the period from January 1 through the date of death. The final return is due on the normal date—meaning 4/15/17 for a decedent who died in 2016 (unless an extension to 10/15/17 is obtained). If the decedent was unmarried, the final Form 1040 is prepared in the usual fashion. When there is a surviving spouse, the final Form 1040 can be a joint return filed by the surviving spouse as if the decedent was still alive as of the end of the year in which he or she died. The final joint return includes the decedent’s income and deductions up to the date of death plus
the surviving spouse’s income and deductions for the entire year.

Executor Has Two Options for Unpaid Medical Expenses
To claim a federal income tax deduction for medical expenses that were unpaid on the date of death, the executor must affirmatively waive the right to deduct those liabilities from the decedent’s taxable estate for federal estate tax purposes. In effect, the election to claim an income tax deduction and the related waiver of any estate tax
deduction gives the executor two options for how to handle medical expenses that are unpaid on the date of
death.
Option 1: Claim Income Tax Deduction. The executor can make the election to claim a federal income tax deduction by waiving the right to claim a federal estate tax deduction.
Option 2: Claim Estate Deduction. The executor can forego the income tax deduction (by forgoing the aforementioned election) and instead claim a federal estate tax deduction.
Note: Medical expenses paid by the decedent during the year of death (but prior to death) are only deductible on the decedent’s final income tax return.
Of course, when no federal estate tax is due (because the decedent’s estate is valued at less than the relatively generous federal estate tax exemption of $5.45 million for those who died in 2016 or $5.49 million for those who die in 2017), Option 2 has no value. So, if Option 1 would result in income tax savings, then Option 1 election should be made.
On the other hand, Option 2 is generally the correct choice when there is a taxable estate because the federal estate tax is currently assessed at a 40% rate while the current maximum federal income tax rate is “only” 39.6%. In addition, medical expenses deducted on the federal estate tax return (Form 706) are unaffected by the percent-of-AGI limitations that apply for federal income tax purposes. Finally, the increased income tax liability from not deducting the medical expenses for income tax purposes will reduce the taxable estate.
For all these reasons, the election to forego an estate tax deduction in favor of an income tax deduction (Option 1) is generally appropriate only when there is no federal estate tax liability. Note that the federal estate tax return (Form 706) is due nine months after the decedent’s date of death. However, the executor can obtain an automatic six-month extension by filing Form 4768.

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Deducting Mortgage Interest with more than one owner

Deducting Mortgage Interest When More Than One Owner Is Liable

Subject to certain limitations, home acquisition debt is deductible as an itemized deduction. Home acquisition debt is debt incurred to acquire, construct, or substantially improve your main or second home. The debt must be secured by the home and is limited to $1 million ($500,000 if married filing separately). To qualify for deduction, you must generally be liable for the debt. When more than one taxpayer is jointly and severally liable on the debt, the taxpayer who makes the mortgage payments is entitled to the deduction with respect to those payments.

 The IRS addressed who is entitled to the mortgage interest deduction when two individuals who are jointly and severally liable on the mortgage make mortgage payments from a joint account or from their separate funds. According to the IRS, funds paid from a joint account with two equal owners are presumed to be paid equally by each owner (without evidence to the contrary). However, if the mortgage interest is paid from separate funds, each taxpayer is entitled to deduct all of the interest he or she pays with separate funds.

 Situation 1. Taxpayers are a married couple and are jointly and severally liable on a mortgage, but one spouse dies during the year and the bank issues a Form 1098 under the deceased spouse’s social security number. The surviving spouse files a separate return.

In the year of death, if the surviving spouse files a separate return, the deceased spouse’s return should include income and deductions to the time of death. In determining the amount of interest deductible on the deceased spouse’s return—

 If the interest payments are made from the couple’s joint account, half of the interest paid before the time of death is deducted on the deceased spouse’s return. The remaining interest is deductible on the surviving spouse’s return.

 If the interest payments are made from the deceased spouse’s separate funds, all of the interest paid before the time of death is deducted on the deceased spouse’s return. The remaining interest is deductible on the surviving spouse’s return, assuming it is paid by the surviving spouse.

 If all of the interest payments during the year are made from the surviving spouses separate funds, no interest is deducted on the deceased spouse’s return. All of the interest is deductible on the surviving spouse’s return.

Presumably, if the couple resides in a community property state, interest paid before the deceased spouse’s death would be split equally between spouses if paid with community property funds and the separate funds rule would apply only to payments made with separate property funds.

In following years, as the surviving spouse is liable on the debt, he or she will be entitled to deduct any interest he or she pays on the mortgage, assuming all other requirements are met.

 Situation 2. Taxpayers are an unmarried couple and are jointly and severally liable on a mortgage, and the bank either issues a Form 1098 under only one social security number, or both. Since both taxpayers are liable on the mortgage, both are entitled to claim the mortgage interest deduction to the extent it is paid by either taxpayer. If the interest is paid from separate funds, each taxpayer may claim the mortgage interest deduction for amounts paid with their own separate funds. If the mortgage interest is paid from a joint bank account it is presumed that each has paid an equal amount absent evidence to the contrary (Rev. Rul. 59-66).

Situation 3. Related persons co-own a house and are liable on a mortgage note. A bank may issue a Form 1098 under the name of one or both of the co-obligors. If co-owners of the house are both liable on a mortgage, each one may take a deduction for the amount each one pays subject to the limitations.

Note: In general, to claim an interest deduction it is necessary to be liable on the note. However, taxpayers can deduct interest paid on a mortgage if they are the legal or equitable owner of the mortgaged real estate, even if they are not directly liable on the debt (Reg. 1.163-1). An equitable owner is a person who has the economic benefits and burdens of ownership, based on the facts. Occupying and maintaining the home and paying the mortgage and taxes on it are factors that might indicate equitable ownership.