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An Inheritance can be a Taxing Experience

by
Evelyn Hsu
on
10/4/2015
An Inheritance can be a Taxing Experience

The tax rules regarding inheritance are extremely complex, and confusion and mistakes can lead to serious negative repercussions. If you have recently come into an inheritance, or believe that there is an inheritance in your future, it is a good idea to learn the basics of inheritance tax in order to avoid unnecessary exposure and minimize your taxes owed.

In most cases, before an inheritance is distributed to an heir all of the applicable taxes have been paid. These taxes can include estate returns, estate or trust income tax returns, decedent's back taxes and final tax return, and more. The inheritance will also already have been reduced by any debts that the decedent owed. Much of the way that the disposition of an estate is managed is determined by how the assets were held – whether in a trust or by the individual – and these same factors dictate what the obligations are for the beneficiary of an inheritance. If the decedent has already paid taxes on the inheritance, and the estate tax has already been paid, then the beneficiary owes no taxes. If on the other hand, the decedent never paid taxes on the items of income then the beneficiary will be liable for taxes on any appreciation or depreciation. 

To get an idea of exactly how the different scenarios might play out, we'll look at a few different types of inheritance.

  • Capital Assets – An inherited capital asset might be collectibles, real estate, stocks or other real property. In order to determine whether the heir has incurred a gain or loss when they sell a capital asset, the value of the item at the time of the decedent's death must first be established, and this is usually done via a qualified appraisal. For example, if an heir inherits a piece of real estate that is valued at $15,000 at the time of death and then sells it for the same amount, there is no tax liability for the heir because there was no gain or loss. However, if the property is sold for more or less than the appraised value then the heir would have a gain or loss that would need to be reported. One of the most important factors when calculating capital gains taxes is usually how long the property was held, as assets that are held for more than a year are usually subject to less tax than those that are sold quickly, but this is not the case for assets that are inherited. They are treated as though they have been held for a long period of time, no matter how long either the decedent or their heir held it. Any expenses involved in selling the asset are deducted from the gain or loss. Going back to our example of the piece of property, if the heir chooses to hold on to the lot and doesn't sell it, then not only does he not have to pay any tax on it but when he dies it will be valued based upon its appraised value at the time of his death, starting the cycle over again for his heirs.
  • Bank Account – If a decedent leaves a bank account valued at $25,000 to their heir and the account earns interest before the money is distributed, then only the interest is taxable as income – the $25,000 inheritance is not.
  • Qualified Retirement Plan or IRA – Inheriting a traditional IRA generally means that the heir is responsible for paying taxes on the account's distribution. This is because no taxes were ever paid on the funds in the account, and were meant to be taxable to the decedent when he withdrew them. Taxes remain due when the monies are distributed, so therefore the heir is liable for the taxes. In order to offset the impact of this tax liability, the beneficiary can opt to withdraw the income over a number of years.
  • Life Insurance – The beneficiary of a life insurance policy's death benefit is not generally liable for the proceeds that they receive. However, any interest that is earned on the amount to be paid before it is distributed will be taxable as income for the heirs.
  • Installment Sale Notes or Annuities – When a decedent owned either an annuity or an installment sale note on a previously-sold property, then their basis was not taxable but their beneficiary will owe taxes for any gain on their basis. The basis is determined based on what was paid if the asset was an annuity. When the inheritance is an installment note, the return of the portion of the asset's cost is what is considered the basis. It is not taxable. Both the portion from the prior sale and the interest on the note are taxable.

When a person dies, the trust or estate must file the appropriate income tax return as well as report any income earned by the estate or trust after the death occurs and before distribution of the inheritance. When the distribution is made, each heir will be provided with a Schedule K-1 (1041) form which will detail their share of the income. This information is required on the heir's individual tax return for that year. In some cases the estate may pay the income tax on the distributed income, but this happens infrequently because the tax liability for the estate is usually higher than that of the heir. It is the responsibility of the trustee or executor to ensure that the tax returns that are required of the estate have been filed ad that all of the heirs receive their K-1 forms.

In some cases, an heir may be responsible for taxable income even before they receive their inheritance. Because of this and other potential complications, it is advisable for anybody that is expecting an inheritance, or who has recently been notified of an inheritance, to consult with a tax professional for guidance.

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Evelyn Hsu

Evelyn Hsu

Ivy Accounting, Tax & Advisory is a Certified Public Accountant (CPA) practice based in Miami, Florida. Evelyn Hsu is the principal in charge of the accounting and auditing practice and is CPA licensed in the state of Florida. She graduated from the University of Miami with a Master's degree in Accounting. Her company has provided a wide range of accounting and tax services to businesses and individuals for many years. She specializes in services to individuals, to small businesses and in representation before the Internal Revenue Service. Evelyn can assist you with all of your tax preparation needs.

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