Inheritance Taxes – how are they taxed anyway? This is a frequently misunderstood taxation issue, and the answer can be complicated. This article will help you understand more about inheritance taxes, how they work and how they are taxed.
When someone passes away, all of their assets (their estate) will be subject to estate taxation. Meanwhile, whatever is left after paying the estate tax, passes to the deceased’s beneficiaries.
Inheritance Taxes – Estate Values and Inflation Adjustments
Sound bleak? All things considered, it’s not a cause for worry as very few decedents’ estates ever pay any estate tax. This is primarily because the tax code exempts a considerable amount of the estate’s value from taxation. Thus, only very large 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. This includes plans to be inflation-adjusted in future years. In brief, estates valued at $11,580,000* or less will not pay any federal estate taxes.
Those estates in excess of the exemption amount only pay estate tax on the excess amount. interestingly, there are less than 10,000 deaths each year for which an estate exceeds the exemption amount. So for most estates, there will be no estate tax and the beneficiaries will generally inherit the entire estate.
* Note that, as with anything tax-related, the exemption is not always a fixed amount. Overall, the exemption must be reduced by prior gifts in excess of the annual gift exemption, and it can be increased for a surviving spouse by the decedent’s unused exemption amount.
FMV of Assets and How It Affects Inheritance Taxes
Of course, once a beneficiary (aka: an heir) receives the inherited asset, any income generated by that property will be taxable to the beneficiary. Similarly, as if the property had always been the beneficiary’s. Altogether, this is the case whether it includes cash, rent from real estate, dividends from stocks etc.
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, beneficiaries 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. That is, the FMV at date of death.
Example of Assets and How They Affect Inheritance Taxes
Example #1: Joe inherits shares of XYZ Corporation from his father. 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. In addition, the gain will be a long-term capital gain. This is 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 home on the date of his father’s death. However, unlike the stock, the home needs to be appraised to determine its FMV. It is highly recommended that a certified appraiser perform the appraisal. Also, that the appraisal be done reasonably close in time to the decedent’s date of death. This is frequently overlooked and can cause problems if the IRS challenges the amount used for the basis.
A Step Up in Basis and How it Affects Inheritance Taxes
This FMV valuation of inherited assets is frequently referred to as a step up in basis. This is really a misnomer because the FMV can, under some circumstances, also be a step down in basis.
If the following is true:
- the decedent was married at the time of death
- and resided in a community property state,
- and if the property was held by the couple as community property,
the beneficiary spouse will generally receive a basis equal to 100% of the FMV of the property. This is even though the spouse will have only inherited the deceased spouse’s share.
Inherited Assets With No FMV And How Beneficiary is Taxed
Not all inherited assets received by the beneficiary fall under the FMV regime. For example, if the decedent held assets that included deferred untaxed income, those assets will be treated differently by the beneficiary. Specifically, examples include inherited:
Traditional IRA Accounts
IRA accounts are taxable to the beneficiaries. But special rules generally allow a spouse beneficiary to spread the income over the surviving spouse’s lifetime. Although, the distribution period is capped at 10 years for most non-spouse beneficiaries if the decedent died after 2019. Previously, the rules allowed most non-spouse beneficiaries of decedents who died prior to 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 personal services.
Pension Payments
These are generally taxable to the beneficiary.
Installment Sales
Sometimes taxpayers will structure sales of property, so the buyer pays the seller with interest over several years. Thus, this is referred to as an installment sale. Whoever receives an installment obligation as a result of the seller’s death is taxed on the installment payments. Of course, this would be in the same manner as the seller, 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 related to the tax ramifications of an inheritance, please give this office a call.
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