Randy J. Elder, CPA, P.C.

Inheritance and taxes: what you need to know

If you have recently received an inheritance or anticipate that you will receive one in the near future, there are tax considerations that you should be aware of. If you are receiving an inheritance, it is likely it is a very emotional time and many details to be taken care of. Claiming an inheritance can quickly become a very complex process so gaining an understanding the tax implications of an inheritance combined with some upfront planning can help you through the process and lighten your burden during this time.

Family

In general, an heir receives his or her inheritance after taxes and liabilities have been paid. Inherited items on which the decedent had already paid taxes and upon which the estate tax (if any) has been paid will pass to the beneficiary tax-free. However, if taxes are owed or liabilities exist – these must be paid first. This includes taxes owed as a result of any appreciation or depreciation of assets.

To help give you a clear picture on taxes and inheritances, I’ve included some common scenarios here.

Bank Account

Any interest income earned on the account after the decedent’s date of death and up to the time at which the funds are paid to the beneficiary are taxable as interest income to the heirs.

Capital Asset

This includes items such as stock, real estate, collectibles etc. If you inherit any capital assets and subsequently sell, the basis for gain or loss is generally determined by the value of the asset at the time of the decedent’s death. So make sure you have a qualified appraisal. Under normal circumstances assets held longer than one year are generally taxed substantially less than those held for a shorter period of time. However, for inherited property, the beneficiary receives long-term treatment immediately, whether or not the decedent or the beneficiary had held it for more than one year. Expenses incurred in selling the inherited capital asset are deductible when calculating the income or loss. If you inherit capital assets but do not sell, you do not have any income or loss associated with that capital asset so there are no tax obligations.

This includes items such as stock, real estate, collectibles etc. If you inherit any capital assets and subsequently sell, the basis for gain or loss is generally determined by the value of the asset at the time of the decedent’s death. So make sure you have a qualified appraisal. Under normal circumstances assets held longer than one year are generally taxed substantially less than those held for a shorter period of time. However, for inherited property, the beneficiary receives long-term treatment immediately, whether or not the decedent or the beneficiary had held it for more than one year. Expenses incurred in selling the inherited capital asset are deductible when calculating the income or loss. If you inherit capital assets but do not sell, you do not have any income or loss associated with that capital asset so there are no tax obligations.

IRA or Other Qualified Retirement Plan

If you inherit a traditional IRA and the distributions would have been taxable to the decedent, then you will be responsible for taxes on the distributions. You can take the distributions over a number of years to soften the tax blow.

Life Insurance Proceeds

Generally, the proceeds from a life insurance policy are tax-free to the heirs. However, if the policy is not paid immediately, as most are not, the insurance company will include interest. That interest is taxable to the heirs.

Annuities and Installment Sale Notes

If you receive an annuity or installment sale note as part of your inheritance, you will be obligated to pay tax on any amount received in excess of the decedent’s basis. The basis would be the amount paid for an annuity. For an installment note, payments include: (1) a return of a portion of the asset’s cost (basis), which is not taxable; (2) a portion from the prior sale of the asset, which is taxable as a capital gain; and (3) taxable interest on the note.

If you receive an annuity or installment sale note as part of your inheritance, you will be obligated to pay tax on any amount received in excess of the decedent’s basis. The basis would be the amount paid for an annuity. For an installment note, payments include: (1) a return of a portion of the asset’s cost (basis), which is not taxable; (2) a portion from the prior sale of the asset, which is taxable as a capital gain; and (3) taxable interest on the note.

An income tax return must be filed by the trust and income earned by the estate or trust after the decedent’s passing and before the assets are distributed to the heirs must be reported. In most instances each heir will receive Schedule K-1 (1041). It will include that heir’s share of income and must be included on the heir’s individual tax return. In some cases the trust or estate may pay the income tax on the income. The executor or trustee is responsible for making sure the required tax returns are filed and for sending K-1s to the heirs.

Please call this office if you are or expect to be a beneficiary and need assistance with the tax obligations of an inheritance.