How Does the Federal Estate Tax Work?

The federal estate tax is a levy on the transfer of property upon a person’s death. It is not a tax on the property itself, but on the right to transfer that property to heirs. The tax is calculated based on the value of the assets the deceased person owned or had an interest in at the time of their passing, which is known as the “gross estate.”

The estate, through its executor, is responsible for paying any tax due. This differs from an inheritance tax, where beneficiaries are responsible for paying tax on the assets they receive. The federal estate tax system is designed to apply only to the wealthiest estates, with a substantial exemption amount shielding the vast majority of estates from any tax liability.

Determining Applicability of the Tax

An estate’s value relative to the federal estate tax exemption determines if it is subject to the tax. For 2025, the exemption is $13.99 million per individual. Estates with a total value below this threshold do not pay federal estate tax. This high exemption is a result of the Tax Cuts and Jobs Act of 2017 and is scheduled to revert to about $7 million in 2026 if not extended by Congress.

Portability allows a surviving spouse to use any unused portion of their deceased spouse’s exemption. For example, if a spouse dies in 2025 with an $8 million estate, the remaining $5.99 million of unused exemption can be transferred to the surviving spouse. This election must be made on a timely filed estate tax return for the deceased spouse.

The rules differ for U.S. citizens and non-resident aliens. U.S. citizens are taxed on their worldwide assets and receive the full exemption. Non-resident aliens are taxed only on their U.S.-sited assets, like real estate, and have a much lower exemption of $60,000.

Calculating the Gross Estate

The first step is to calculate the decedent’s gross estate by identifying all property the person owned or had an interest in at the date of death. The value used is the Fair Market Value (FMV) of each asset, which is the price it would sell for on the open market, not its original cost. The gross estate is comprehensive and includes a wide range of assets.

• Cash, bank accounts, stocks, bonds, mutual funds, and real estate
• Interests in closely held businesses, partnerships, and sole proprietorships, which often require a professional appraisal to determine the business’s FMV
• Proceeds from a life insurance policy if the decedent possessed any “incidents of ownership” in the policy, such as the right to change the beneficiary or cancel it
• Retirement accounts, such as 401(k)s and Individual Retirement Accounts (IRAs)

Assets held in a revocable living trust are part of the gross estate because the person who created the trust retained control over the assets. Furthermore, the tax code has provisions to prevent individuals from avoiding estate tax by giving away assets right before death. Under the “three-year rule,” certain transfers made within three years of death, such as relinquishing control over a life insurance policy, can be included in the gross estate.

An executor has the option to value the estate’s assets either as of the date of death or on an Alternate Valuation Date, which is six months after the date of death. This alternative can be chosen only if it results in a decrease in both the gross estate’s value and the estate tax liability.

Allowable Deductions and the Taxable Estate

After determining the value of the gross estate, certain allowable deductions are subtracted. These deductions reduce the overall value of the estate to arrive at the “taxable estate,” which is the amount upon which the tax is calculated.

• Marital Deduction: This allows for the tax-free transfer of any amount of property from the deceased spouse to their surviving spouse, provided the surviving spouse is a U.S. citizen. This deduction is a primary reason why many estates do not owe tax at the death of the first spouse.
• Charitable Deduction: The full value of any property or funds left to a qualified charitable organization that meets IRS requirements can be deducted from the gross estate.
• Debts and Obligations: The estate can deduct the decedent’s debts that existed at the time of death. This includes mortgages, personal loans, credit card balances, and accrued property or income taxes.
• Administrative Expenses: The costs associated with settling the estate are deductible. These are known as administrative expenses and include funeral expenses, executor fees, attorney and accountant fees, and appraisal costs.

Estate Tax Computation and Credits

Once the taxable estate is determined, a progressive tax rate schedule is applied to arrive at a tentative tax amount. The tax rates start at 18% on the first $10,000 of taxable value and increase to a maximum rate of 40% for amounts over $1 million above the exemption.

After calculating the tentative tax, the estate applies the unified credit. This is a dollar-for-dollar credit that directly reduces the amount of estate tax owed. The federal exemption amount is the lifetime value of transfers that are shielded from tax by this credit. This credit unifies the gift tax and estate tax systems, meaning that taxable gifts made during one’s lifetime reduce the amount of credit available to offset estate tax at death.

An estate will only owe tax if its value, plus any lifetime taxable gifts, exceeds the exemption amount for the year of death. Beyond the unified credit, a credit for tax on prior transfers (TPT) may be available. This credit provides relief if the decedent received property from another estate that was also subject to estate tax within the 10 years preceding the decedent’s death.

Filing the Estate Tax Return

The executor of the estate is responsible for reporting and paying the federal estate tax by filing a specific tax form with the IRS. A return is required if the decedent’s gross estate, plus any adjusted taxable gifts made during their lifetime, exceeds the federal exemption amount for the year of death. A return must also be filed if the estate wishes to elect portability of the deceased spouse’s unused exemption (DSUE) to the surviving spouse.

The official document for this process is IRS Form 706, the United States Estate (and Generation-Skipping Transfer) Tax Return. On this form, the executor reports the detailed calculation of the gross estate, lists all deductions, and computes the final tax liability.

The deadline for filing Form 706 is nine months after the date of the decedent’s death. An automatic six-month extension can be requested by filing Form 4768, but an extension to file is not an extension to pay. Any estimated tax due must still be paid by the nine-month deadline to avoid penalties and interest.

After the return is filed, the IRS may issue an estate tax closing letter, which formally concludes the estate’s federal tax obligations. For estates that consist largely of a closely held business or farm, the tax may be paid in installments over a period of up to 14 years, though interest will apply.