Inheriting property or money can be a significant financial event, but it also comes with tax implications that beneficiaries must understand. While inheritances are generally not subject to federal income tax, there are other tax considerations, such as estate taxes, capital gains taxes, and state-specific inheritance taxes. This article provides a detailed overview of the tax implications of inheriting property or money and offers practical advice.
Federal Income Tax on Inheritances
In most cases, property or money received as an inheritance is not subject to federal income tax. According to the IRS, inheritances, whether in the form of cash, real estate, or other assets, are excluded from the recipient’s gross income. However, any income generated by the inherited property after it is received is taxable.
Example: If you inherit $100,000 in cash from a relative, you do not need to report this amount as income on your federal tax return. However, if you deposit the money into a savings account and earn $1,000 in interest, the interest is taxable and must be reported.
Estate Taxes
The federal estate tax applies to the total value of a deceased person’s estate before it is distributed to beneficiaries. For 2024, the federal estate tax exemption is $13.61 million per individual. Estates valued below this threshold are not subject to federal estate tax.
Example: If a decedent’s estate is worth $10 million, no federal estate tax is owed because the value is below the $13.61 million exemption. If the estate were worth $15 million, the excess $1.39 million is subject to federal estate tax. It is important to note that the estate, not the beneficiary, is responsible for paying any federal estate tax owed.
State Inheritance and Estate Taxes
Some states impose inheritance taxes or estate taxes, which are separate from federal taxes. Inheritance taxes are paid by the beneficiary, while estate taxes are paid by the estate.
- Inheritance Tax: States like Pennsylvania, Iowa, Kentucky, Maryland, and Nebraska impose inheritance taxes. The tax rate and exemptions depend on the beneficiary’s relationship to the decedent. For example, spouses and children often receive preferential tax treatment or exemptions
- Estate Tax: States like Oregon, Massachusetts, and New York impose estate taxes with lower exemption thresholds than the federal government
Example: If you inherit $500,000 from a relative in Pennsylvania, you may owe inheritance tax depending on your relationship to the decedent. For instance, the tax rate for children is 4.5%, while siblings pay 12%.
Capital Gain Tax on Inherited Property
When you inherit property, such as real estate or stocks, the basis of the property is typically adjusted to its fair market value (FMV) on the date of the decedent’s death. This is known as a step-up in basis and can significantly reduce capital gains taxes if you sell the property.
Example: Suppose your parent purchased a home for $100,000, and it was worth $500,000 at the time of their death. If you inherit the home and sell it for $510,000, your taxable gain is only $10,000 ($510,000 sale price – $500,000 stepped-up basis). Without the step-up in basis, your taxable gain would have been $410,000. However, if the property appreciates after you inherit it, you may owe capital gains tax on the increase in value when you sell it.
Inherited Retirement Accounts
Inheriting a retirement account, such as an IRA or 401(k), has specific tax implications. The rules depend on whether you are a spouse or a non-spouse beneficiary.
- Spouse Beneficiaries: Spouses can roll over the inherited account into their own IRA and defer taxes until they take distributions
- Non-Spouse Beneficiaries: Non-spouse beneficiaries must generally withdraw the entire account balance within 10 years under the SECURE Act. These withdrawals are taxable as ordinary income
Example: If you inherit a traditional IRA worth $200,000 and withdraw $50,000 in a given year, the $50,000 is added to your taxable income for that year.
Income in Respect of a Decedent (IRD)
Income that the decedent was entitled to but did not receive before their death is considered Income in Respect of a Decedent (IRD) and is taxable to the beneficiary. Common examples include unpaid wages, dividends, or distributions from retirement accounts.
Example: If your parent was owed $10,000 in rental income at the time of their death, and you receive this income as the beneficiary, you must report it as taxable income.
Deductions for Estate Taxes Paid
If you inherit property that was subject to federal estate tax, you may be eligible for an estate tax deduction on your income tax return. This deduction applies to income in respect of a decedent (IRD).
Example: If you inherit a retirement account worth $1 million and $200,000 of it was subject to estate tax, you can deduct the estate tax attributable to the $200,000 when you withdraw the funds.
Practical Advice for Beneficiaries
To navigate the tax implications of an inheritance effectively, consider the following tips:
- Understand the Value of the Inheritance: Obtain a valuation of the inherited property or assets to determine their fair market value and potential tax implications
- Consult with a Tax Professional: Tax laws surrounding inheritances can be complex, especially if the estate involves multiple types of assets or spans multiple states. A tax professional can help you understand your obligations and minimize your tax liability
- Plan for Taxes on Income-Generating Assets: If you inherit income-generating assets, such as rental property or stocks, be prepared to pay taxes on the income they produce
- Consider Selling Inherited Property Strategically: If you plan to sell inherited property, consider the timing to minimize capital gains taxes. For example, selling shortly after inheriting the property may result in little to no taxable gain due to the step-up in basis
- Review State Tax Laws: If the decedent lived in a state with inheritance or estate taxes, research the applicable laws to determine your tax liability
- Keep Detailed Records: Maintain records of the inherited property’s value, any income it generates, and any taxes paid. This documentation will be essential for tax reporting
Inheriting property or money can have significant tax implications, ranging from federal estate taxes to state inheritance taxes and capital gains taxes. Understanding these rules and planning accordingly can help beneficiaries minimize their tax burden and make the most of their inheritance.
