- Estate Tax
- Estate Tax Exemption
- Fair Market Value at Date of Death
- Step up in Basis
- Community Property
- Deferred Untaxed Income
Are inheritances taxable? This is a frequently misunderstood taxation issue, and the answer can be complicated. When someone passes away, all of their assets (their estate) will be subject to estate taxation, and whatever is left after paying the estate tax passes to the decedent’s beneficiaries.
Sound bleak? Don’t worry, very few decedents’ estates ever pay any estate tax, primarily because the tax code exempts a liberal amount of the estate’s value from taxation; thus, only extensive estates are subject to estate tax. In fact, with the passage of the Tax Cuts & Jobs Act (tax reform), the estate tax exemption has been increased to $11,580,000* for 2020 and will be inflation-adjusted in future years. That generally means that estates valued at $11,580,000* or less will not pay any federal estate taxes, and those over the exemption amount only pay estate tax on the excess amount. Of interest, there are less than 10,000 deaths each year. The decedent’s estate exceeds the exemption amount, so there will be no estate tax for most estates, and the beneficiaries will generally inherit the entire estate.
* Note that, as with anything tax-related, the exemption is not always a fixed amount. Prior gifts must reduce it above the annual gift exemption, and it can be increased for a surviving spouse by the decedent’s unused exemption amount.
Of course, once a beneficiary (also referred to as an heir) receives the inherited asset, any income generated by that property—be it interest from cash, rent from real estate, dividends from stocks, etc.—will be taxable to the beneficiary, just as if the property had always been the beneficiaries.
Because the value of an estate is based upon the fair market value (FMV) of the assets owned by the decedent on the date of their death (or in some cases, an alternative valuation date six months after the decedent’s date of death, which is rarely used), the beneficiaries will generally receive the inherited assets with a basis equal to the same FMV determined for the estate. What this means to a beneficiary is that if they sell an inherited asset, they will measure their gain or loss from the inherited basis (FMV at date of death).
Example #1: Joe inherits shares of XYZ Corporation from his father. Because XYZ Corporation is a publically traded stock, the FMV can be determined by what it is trading for on the stock market. Thus, if the inherited basis was $40 per share and the shares are later sold for $50 a share, Joe will have a taxable gain of $10 ($50 – $40) per share. The increase will also be a long-term capital gain since all inherited assets are treated as being held long-term by the beneficiary. On the flip side, if the shares are sold for $35 a share, Joe would have a tax loss of $5 per share.
Example #2: Joe inherits his father’s home. Like other inherited property, Joe’s basis is the FMV of the house on the date of his father’s death. However, unlike the stock, the FMV, which could be determined from the trading value, the home needs to be appraised to determine its FMV. It is highly recommended that a certified appraiser perform the appraisal and be done reasonably close in time to the decedent’s death date. This is frequently overlooked and can cause problems if the IRS challenges the amount used for the basis.
This FMV valuation of inherited assets is frequently referred to as a step-up in basis, which is a misnomer because the FMV can, under some circumstances, also be a step down in basis.
If the decedent was married at the time of death and resided in a community property state, and if the couple held the property as community property, the beneficiary spouse will generally receive a basis equal to 100% of the FMV of the property, even though the spouse will have only inherited the deceased spouse’s share.
Not all inherited assets received by the beneficiary fall under the FMV regime. If the decedent held assets that included deferred untaxed income, they would be treated differently by the beneficiary. Examples of those include inherited:
Traditional IRA Accounts – These are taxable to the beneficiaries. Still, special rules generally allow a spouse beneficiary to spread the income over the surviving spouse’s lifetime, while the distribution period is capped at ten years for most non-spouse beneficiaries if the decedent died after 2019. Previously, the rules allowed most non-spouse beneficiaries of decedents who died before 2020 to use a lifetime distribution method.
Roth IRAs – Qualified distributions are not taxable to the beneficiary.
Compensation – Amounts received after the decedent’s death as compensation for their services.
Pension Payments – These are generally taxable to the beneficiary.
Installment Sales – Sometimes taxpayers will structure sales, usually of real property, so that the buyer pays the seller for the purchase with interest over several years. This is referred to as an installment sale. Whoever receives an installment obligation due to the seller’s death is taxed on the installment payments the same as the seller would have been had the seller lived to receive the payments.
This is just an overview of issues related to being the beneficiary of an inheritance. If you have questions about the tax ramifications of a potential or actual estate, please contact us.