When someone dies, their final tax return is subject to a number of special rules. The deemed disposition rule in particular can have a major impact on the final tax bill.

What is a deemed disposition?

It’s a form of capital gain

To understand deemed disposition it’s first important to understand the basics of what a capital gain is.

When a taxpayer sells an asset, a calculation is done to compute the capital gain or capital loss (i.e., the profit or loss on the sale). In its simplest form, the total capital gain is the selling price minus the seller’s original purchase price.

The special case of the deemed disposition

In the case of a deceased person’s final return, all their assets are deemed to have been sold at the time of death, and the capital gain or loss is calculated on that basis. This ‘sale’ when no actual sale has taken place is called a deemed disposition.

Calculating the tax on the final return

But with no actual sale, how can you calculate a sale price? In the case of a deemed disposition for a final return, we use the fair market value (FMV) as the sale price for tax purposes.

For example, a person may have an investment portfolio at the time of death. The funds are tied up in equities and bonds, but they are all considered to have been sold at fair market value at the time of death, and the capital gain (if any) is added to the final tax return as income.

If the asset being bequeathed is physical, such as real estate, it may be necessary to bring in a professional to provide a realistic FMV for tax purposes.

Why the deemed disposition on the final tax return matters

Why this all matters is that the deemed disposition — which usually does generate a capital gain — can add a large amount of income to the final return, far more than the deceased typically earned while alive. And that surge of income can push the total income into a higher tax bracket.

Consequently, the taxes on a final return can be very high, both because the apparent income (including the deemed disposition) is high, and because some of that income is subject to a higher marginal tax rate.

With the understanding of this potential income surge in the year of death, a great deal of estate planning revolves around finding ways to spread the capital gain out over some of the preceding years by strategically liquidating and/or giving away assets late in life.