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Circular 230 Disclosure, United States Treasury regulations effective June 21, 2005 require us to notify you that to the extent of this communication, or any of its attachments, contains or constitutes advice regarding any U.S. Federal tax issue, such advice is not intended or written to be used, and cannot be used, by any person for the purpose of avoiding any penalties that can be imposed by the Internal Revenue Service.
Inheritances Can Be Tricky
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.
To explain this further, let us assume that a vacant parcel of land is inherited, with a date of death appraisal that values it at $15,000. If that property is sold for a net price of $15,000, there will have been neither gain nor loss and the $15,000 is tax-free to the beneficiary (the transaction, however, must still be reported by the beneficiary on his or her tax return). If, on the other hand, the net sales price is more or less than the $15,000, there would be a reportable capital gain or loss. For capital gains tax purposes, the holding period is important. Assets held for over one year are generally taxed substantially less than those held for shorter periods of time are. However, for inherited property, the beneficiary receives long-term treatment immediately, whether or not the decedent or the beneficiary has held it for over one year. If there are expenses associated with selling the asset, then those expenses are deductible in calculating the gain or loss.
- 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.
A trust or estate is required to file an income tax return and to report income earned by the estate or trust after the decedent's passing and prior to distribution of the assets to the heirs. Each heir will generally receive a form called Schedule K-1(1041), which will include specifications regarding the heir's share of income that must be included on the heir's individual tax return. Although infrequently occurring (because the taxes are generally higher), 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. 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 this office.