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-You said "The $25K should have been deducted as expenses of the estate when you made the payments, so that would have been on the 2009 form 1041, even if you don't receive it until now. If you treat it as a loan from you to the estate, the imputed interest on the loan is additional income to you, even if not paid. Sorry about that"
When I did the 2009 initial 1041, I contact the IRS and tax lawyer (not a cust serv rep) and he said the $25K would not have to be reported at all on the form in either 2009 or the final in 2010. That the estate should just issue me a check before distribution to all beneficiaries are made on the K-1. Then I can use the 25K in improvements to reduce my portion of the cap gains in my 1040.
I have done some research. It appears that perhaps I can use the 25K to reduce the estate tax before distribution so all my sisters benefit rather than just taking it afterwards on my 1040. Then, if I understand the IRS, I will still get reimbursed that 25K from the state.
-The preliminary 1041 showed tax due because I failed to do the income distribution in sch B so i was being taxed on the Cap gains at th estate level. Once I filled in sch B line 18 (I think), the tax became zero.