A frequent question asked is, “Are inheritances taxable?”
This is a common question that often comes with confusion. When someone passes away, their assets may be subject to an inheritance tax before anything is passed on to the beneficiaries.
Sound bleak?
💡 Inheritance Tax - Exemptions
Don’t worry—most estates don’t end up paying inheritance tax. This is because the tax code exempts a substantial portion of the estate from taxation. For example, the federal estate tax typically kicks in for assets over $12.06 million in 2022 and $12.92 million in 2023, with tax rates ranging from 18% to 40%.
Keep in mind, as with all things tax-related, this exemption isn’t always a fixed amount. It can be reduced by prior gifts exceeding the annual gift exemption, or increased for a surviving spouse by using the decedent’s unused exemption amount.
Since the value of an estate is based on the fair market value (FMV) of the assets at the time of death (or an alternative valuation date six months later), beneficiaries usually receive inherited property at this FMV. In practical terms, if a beneficiary sells an inherited asset, they’ll calculate their gain or loss based on the FMV at the time of the decedent’s death.
Inheritance Tax Examples
Example #1: Inherited Stocks
Joe inherits shares of XYZ Corporation from his father. Since XYZ is publicly traded, its FMV can be easily determined by its market price. If the FMV was $40 per share when inherited and the shares are sold later for $50 per share, Joe would have a taxable gain of $10 per share. This gain would be classified as a long-term capital gain because all inherited assets are treated as long-term, regardless of the actual holding period.
On the flip side, if Joe sells the shares for $35 each, he’d incur a loss of $5 per share.
Example #2: Inherited Property
Joe also inherits his father’s home. Unlike stocks, the FMV of the home isn’t as straightforward and requires a professional appraisal. It’s essential to get this right because if the IRS challenges the valuation, it could lead to complications.
This FMV valuation is often called a step-up in basis, although the FMV can also result in a step-down in some cases. If the decedent was married and lived in a community property state, and if the property was held as community property, the surviving spouse generally receives a 100% basis equal to the FMV, even though they only inherit the deceased spouse’s share.
Not All Inherited Assets Are the Same
Not every asset falls under the FMV rule. If the decedent held assets with deferred untaxed income, those will be taxable to the beneficiary.
Examples of Deferred Untaxed Income:
- ✅ Traditional IRA Accounts: Taxable to beneficiaries, but with special rules allowing the income to be spread over five years or the beneficiary’s lifetime.
- ✅ Roth IRAs: Qualified distributions are generally not taxable to the beneficiary.
- ✅ Compensation: Payments received after the decedent’s death for their services.
- ✅ Pension Payments: Typically taxable to the beneficiary.
- ✅ Installment Sales: If the decedent was receiving installment payments, the beneficiary will continue to be taxed on those payments as if the decedent were still alive.
Need More Information on Tax Implications of Inheritances?
If you have questions about the tax consequences of an inheritance—whether you’re planning ahead or dealing with one right now—give us a call. We’re here to help you navigate the complexities and make the most of your inheritance.