Did a loved one recently leave you an inheritance? If yes, you may be liable to pay taxes on the property or cash you received. If you are liable to pay taxes on the property or cash you received and you don't pay taxes to the IRS then you may be need to get some tax relief help.
Three types of taxes apply to inheritances–a capital gains tax if you sell the property, an inheritance tax that a few states impose, and an estate tax which the estate must pay before you can collect your inheritance.
This article covers all you need to know on each of these taxes.
Capital Gains Tax
The IRS collects a tax on the profit you gain from selling specific types of assets such as stocks, bonds, and property.
If you sell an inherited property for a profit, you will pay a capital gains tax.
To calculate the amount of gain or loss you make after selling the property, the IRS uses what is known as a tax basis.
The tax basis is the value of a property when it is sold. Usually, this is the original price the owner paid for it.
For example, if you buy a house for $150,000 and sell it for $180,000, your tax basis would be the original amount you paid ($150,000). Your gain in this instance is $30,000 which is the taxable amount.
When you inherit a property, however, the tax basis is “stepped up”.
This means the value of the property is no longer its original price but the fair market value at the time of the owner’s death.
For example, if your mother paid $100,000 for a house, and you receive it 20 years later.
The tax basis is stepped up to the fair market value of the house on the day she died.
If upon appraisal, the fair market value is $250,000, this will be your tax basis.
So if you sell the house for $300,000, your gain will be $50,000 and that is your taxable amount.
According the IRS, "For more information on basis and adjusted basis, refer to Publication 523, Selling Your Home. If you financed the purchase of the house by obtaining a mortgage, include the mortgage proceeds in determining your adjusted cost basis in your residence."
If you sell an inherited property at a loss, you won’t pay a capital gains tax.
Using the previous example, if you sell the house for less than $250,000, you have a capital loss and not only do you avoid a tax but the amount you lose is tax deductible.
But this only applies if you don’t use the house as a personal residence.
The fair market value of a property can also be determined on a later date rather than the owner’s date of death.
This is known as an alternate valuation date and is usually six months after the death.
People dealing with large estates may find an alternate valuation date useful.
An inheritance tax is a state tax you pay on the assets and properties you inherit.
Only six states still collect this tax–New Jersey, Maryland, Nebraska, Iowa, Kentucky, and Pennsylvania.
If you inherit property from someone who lived in one of these states, you may pay an inheritance tax even if you don’t live there.
Your tax rate will depend on the value of the inheritance and your relationship with the decedent.
Spouses are exempt from paying an inheritance tax.
Children and grandchildren are also exempt in some states or pay a low rate.
If you have no family ties with the descendant, however, you will pay a higher tax rate.
In Nebraska, for example, parents, grandparents, children, siblings, or other direct relations, including those adopted, pay an inheritance tax of 1% on amounts over $40,000.
On the other hand, uncles, aunts, nieces, nephews, and other remote relatives, by blood or adoption, pay an inheritance tax of 13% on amounts over $15,000.
Friends and distant relatives pay 18% on amounts over $10,000. The rates may differ for each state, but the pattern is similar.
An estate tax is a tax levied on the money and property (estate) you want to pass on after you die.
Your estate must pay this tax in full before of your assets can be shared to beneficiaries.
Your benefactor must also pay his/her estate tax before you can receive your inheritance.
The estate tax is calculated based on the total value of your estate on the day you die.
It takes into account your cash, securities, insurance, trusts, annuities, real estate, and business interests.
The fair market value of each property is used to calculate the total value of your estate which is termed the “Gross Estate”.
Any liability such as mortgage, estate administration expenses, and other debts are subtracted from the gross estate.
Whatever is left becomes the taxable estate.
The Federal estate tax has an exemption of $11.8 million as of 2018. If the value of your estate is lower than this, you don’t have to worry about paying a Federal estate tax.
But If your estate exceeds this amount, you pay a 40 percent estate tax rate.
Twelve states–Connecticut, Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New York, Oregon, Rhode Island, Vermont, Washington–and the District of Columbia also collect estate taxes.
Most states have the same exemption amount as the Federal government, but some states have a lower exemption amount.
Oregon, for example, has an exemption of $1 million. Estates exceeding this amount pay a tax rate of 10% to 16%.
Spouses don’t pay estate taxes on the property left to them no matter the value.
Charities also don’t have to pay an estate tax if they are gifted money or other assets from an estate.
Difference Between Inheritance Tax and Estate Tax
Inheritance and estate taxes are both called “death taxes” and are often used interchangeably.
The difference, however, is who pays the tax.
The owner of an estate pays the estate tax.
While beneficiaries of an estate pay the inheritance tax.
If you are a beneficiary of an estate you are responsible for paying your inheritance tax.
4 Ways to Protect Your Inheritance from Taxes
1. Don’t Immediately cash in on Inherited IRA/401k Plans
If you inherit a retirement account from someone other than your spouse, explore your options before cashing it in.
Most retirement accounts are not taxed yet so any amount you withdraw is included in your tax return as a taxable income.
You can end up paying anywhere between 25% to 39.6% on federal taxes if you withdraw the entire amount in an IRA/401k account at once.
Your best option is to stretch out your withdrawals.
You can set up an inherited IRA account with you as the beneficiary and take out the required minimum distributions (RMDs) each year according to your life expectancy.
The great thing about ‘stretching’ the IRA in this way is that you only pay taxes on the amount you withdraw while the rest of the money in the account continues to grow tax-deferred.
Talk with the plan administrator if you inherit a 401(K), you to map out the best plan for your inherited funds.
2. Receive your inheritance as gifts
If you are expecting an inheritance from a loved one, you can ask them to gift it to you over time to avoid the tax bill.
The IRS allows a person to make a gift of up to $15,000 per year to as many people they like without paying tax.
In addition, a person can gift up to $11.2 million over their lifetime without paying a gift tax.
Recipients also do not pay tax on what they receive, so this is a win-win situation for both parties.
The gifts can range from a check to an investment account or even a car, as long as it is within the $15,000 cap.
With good planning, you can receive or give part of an inheritance as a gift for several years.
Gifting not only helps you avoid taxes, but you can begin to benefit from your inheritance.
The obvious drawback to gifting is the time it takes to give out a significant portion of a large inheritance.
If you plan on gifting a part of your estate, talk with a professional estate planner.
3. Put your inheritance in a trust
You can ask your benefactor to put any potential inheritance in a trust.
Or you can place future inheritances in a trust fund for loved ones.
Trust funds aren’t only for the super wealthy, middle-class people can also use trust funds to protect their assets after they are gone.
You can put cash, stocks, real estate, and other assets in a trust.
And an attorney can help you set up stipulations for each beneficiary of your estate.
For example, you can decide on a monthly payment to each beneficiary from the trust, or stipulate that beneficiaries can only use the funds for education or health expenses.
There are various types of trust, but the two most common are the revocable and irrevocable trust.
A revocable trust allows your or the benefactor to take out the assets whenever necessary.
While an irrevocable trust ties up the assets until you or the benefactor is dead.
An irrevocable trust is better for tax.
Once your assets are in an irrevocable trust, they are no longer yours and you don’t have to pay income taxes on any money made from them.
You can also suggest an A-B or joint trust to a benefactor especially your parents.
A Joint trust is created by a married couple with each spouse putting assets into the trust.
If one member of the couple dies, the assets are split into two reducing the estate tax bill.
4. Consider the Alternate Valuation Date
If your inherited estate exceeds the $11.8 million exemption amount, you can benefit from using an alternative valuation date.
Usually, the value of an estate is determined on the day the owner dies.
But the executor can always value the estate on a later date, typically six months after the death.
The benefit of this is to give you time to decrease the value of the estate so you reduce or avoid the estate tax.
You can do this by either selling or gifting one or more assets.
For example, if your inherited estate is worth $11.20 million, you can dispose of over $200,00 worth of assets to bring the value below the exemption amount ($11.18 million).
Any property you sell within the six months is valued on the date of sale. You might have to sell some items for less than their fair market value, but it’s cheaper than paying 40% in estate taxes.
Your inheritance is not taxable income, but it may be subject to three types of taxes–capital gains tax, inheritance tax, and estate tax.
If you are unsure whether you have to pay taxes on an inherited property, consult with an accountant or an estate planning attorney
Leave us a reply on any other ways you have benefits from inheritance and taxes.