If you have received an inheritance or anticipate receiving one in the future, this article may answer many of the questions you might have. The process of claiming an inheritance can be quite complex, and it helps to understand the basics and be aware of potential tax liabilities. NOTE: Special rules, not covered in this article, will apply if the decedent’s death occurred during 2010 and the executor elected to apply the “no estate tax” rules available at that time (usually this occurred only if the estate was valued at more than $5 million). If you are a beneficiary under this condition, the executor should provide you with additional information as to the basis of the property you inherited.
An inheritance is generally received after all applicable taxes have been paid, along with any outstanding liabilities the decedent may have had. Exactly how the estate is handled will depend upon whether the assets were owned individually or in a trust. Without going into the intricacies of estates, trusts, and probate, the result for a beneficiary will generally be the same. Inherited items on which the decedent had already paid taxes and which the estate tax (if any) has been paid will pass to the beneficiary tax-free. On the other hand, items of income that have not previously been taxed to the decedent, as well as any appreciation or depreciation of assets acquired from the decedent, will have tax implications. Some possible scenarios are provided below:
- Bank Account – Take for instance, an inherited bank account worth $25,000, where the funds are not immediately distributed to the heir. The $25,000 account earns $375 of interest income after the decedent’s date of death. Out of the $25,375 that is received, the $25,000 is tax-free but the $375 is taxable as interest income. Any future earnings on the $25,000 inheritance are also taxable.
- Capital Asset – The basis for gain or loss resulting from the sale of an inherited capital asset, such as stock, real estate, collectibles, and so forth, is generally based on the value of the asset at the time of the decedent’s death. That is one reason that qualified appraisals are so important.
- IRA or other Qualified Plan – Suppose the decedent had a traditional IRA account and the distributions from that account were taxable to the decedent. If you were to inherit that account, the distributions would be taxable to you as the beneficiary. Why is that? Because the decedent never paid taxes on the income that went to fund the traditional IRA, and therefore you, the beneficiary, will be stuck with the tax liability. The good news is that there are options for payment over a number of years, which can 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 the decedent purchased an annuity or had an installment sale note from the property he previously sold, the decedent’s basis would be tax-free but the heirs would be obligated to pay the tax on any amount received in excess of the decedent’s basis. For an annuity, the decedent’s basis would be what he or she paid for it. 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 that is taxable as a capital gain, and (3) taxable interest on the note.
There may be taxable income to the heir even though the inheritance has not yet been received. In addition, there are other factors to consider that have not been discussed.
If you have questions regarding the treatment of an inheritance you’ve received or are expecting to receive, please contact our office.
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