You Received an Inheritance. Will You Owe Taxes?
The inheritance itself may not be taxable, but what you inherit and what you do next can make a major difference.
Receiving an inheritance often comes during an emotional and demanding time. Along with legal paperwork and financial decisions, beneficiaries frequently ask one immediate question: Will I owe taxes on what I inherited?
For most people, simply receiving an inheritance does not create federal taxable income. Cash, real estate, investments, and other property generally are not included as income on the beneficiary's federal tax return merely because they were inherited.
However, that reassuring answer is only the beginning. The tax treatment depends on the type of asset, the income it produces, and what the beneficiary does with it afterward.
Inherited Cash
Cash received by inheritance generally is not taxable income. If you inherit $50,000 and deposit it into your bank account, the original $50,000 is not reported as income on your federal return.
However, income earned after you receive the money is taxable under the normal rules. Interest from a savings account, dividends from investments, and gains from selling investments may all need to be reported.
Inherited Homes and Other Real Estate
Inherited real estate generally receives a new tax basis equal to its fair market value on the date of the owner's death. This is commonly called a stepped-up basis because property often has appreciated during the owner's lifetime. Technically, the adjustment can also be a step-down if the property has lost value.
Suppose a parent bought a home decades ago for $80,000 and it was worth $400,000 at death. If the beneficiary's basis is $400,000 and the home is sold shortly afterward for approximately that amount, there may be little or no taxable capital gain. If the beneficiary later sells it for $450,000, the potential gain generally begins with the difference between the selling price and the inherited basis, adjusted for selling expenses and other applicable items.
A reliable date-of-death appraisal or other support for fair market value is extremely important. Years later, bank records and property information may be difficult to reconstruct. Beneficiaries should obtain the valuation and preserve it with their permanent tax records.
Inheriting a home also does not automatically provide the full home-sale exclusion available for a taxpayer's principal residence. The beneficiary must independently satisfy the ownership and use requirements to claim that exclusion.
Inherited Stocks and Other Investments
Stocks, mutual funds, and many other investments generally receive the same type of date-of-death basis adjustment. The beneficiary usually is taxed only on the gain that occurs after the valuation date, assuming the asset is later sold for more than its adjusted basis.
The brokerage firm may not always have complete or correct basis information, particularly for older holdings or assets transferred between institutions. Beneficiaries should compare brokerage records with information provided by the executor and retain the estate's valuation documents.
Inherited Traditional IRAs and Retirement Accounts
Retirement accounts are different. A traditional IRA does not receive a stepped-up basis. Withdrawals are usually taxable as ordinary income, except to the extent the account includes previously taxed contributions or another exclusion applies.
Most non-spouse beneficiaries who inherit an IRA from someone who died after 2019 must empty the account by December 31 of the tenth year following the year of death. Depending on whether the original owner had reached the required beginning date, the beneficiary may also have to take annual required minimum distributions during that ten-year period.
The ten-year rule came from the SECURE Act of 2019. Later legislation and IRS regulations added or clarified related requirements. Surviving spouses, minor children of the account owner, disabled or chronically ill beneficiaries, and beneficiaries not more than ten years younger than the owner may qualify for different treatment.
Inherited Roth IRA distributions are often income-tax-free if the applicable requirements are satisfied, but the account generally still must be distributed within the required period. A beneficiary should confirm the rules before taking money out or deciding to postpone distributions until the tenth year. Large withdrawals concentrated in one year can push the beneficiary into a higher tax bracket.
Some Inherited Income Remains Taxable
Not every inherited asset receives a fresh tax basis or escapes income tax. Certain amounts are classified as income in respect of a decedent. These are amounts the deceased person was entitled to receive but had not yet included in taxable income.
Examples can include traditional retirement-account distributions, unpaid compensation, accrued interest on certain savings bonds, and payments from an installment sale. When the beneficiary or estate receives these amounts, they retain their taxable character.
This is one reason beneficiaries should not assume that every inherited payment is tax-free simply because it came from an estate.
State Estate Taxes and Inheritance Taxes Are Different
Some states impose either an Estate Tax or an Inheritance Tax, and the rules depend on where the deceased person lived, where property is located, and the date of death. Beneficiaries and executors should review the laws of every state connected to the estate or inherited property.
More about Estate and Inheritance Taxes à https://www.gurelcpa.com/current-news/estate-vs-inheritance-tax/
Before You Sell, Transfer, or Withdraw Anything
Before making major decisions, a beneficiary should gather and preserve:
- The date-of-death value of real estate and investments.
- Appraisals, estate inventories, and any Schedule A to Form 8971 received from the executor.
- Retirement-account statements and beneficiary information.
- Records showing after-tax contributions to an inherited retirement account, if any.
- Information about unpaid income, installment obligations, or savings bonds.
- The deceased person's state of residence and the location of inherited real estate.
A little planning can prevent the loss of valuable basis information, missed retirement distributions, and an unexpectedly large tax bill. The best time to review inherited assets is before they are sold, retitled, or withdrawn.
The Bottom Line
Most inheritances do not create federal taxable income when received. The important questions come next: What type of asset was inherited? What is its tax basis? Does it contain untaxed income? Will it be sold, invested, rented, or withdrawn from a retirement account?
Each answer can lead to a different tax result. Reviewing the inheritance before taking action can help preserve records, identify deadlines, and allow the beneficiary to make better-informed decisions.
The article is meant for informational purposes only. Please contact me directly to discuss how this applies to your individual tax situation.