Is There a Tax on Inheritance?

Is There a Tax on Inheritance?Pin

Do I Have to Pay Tax on Inheritance of an Estate?

A very broad answer to this question is maybe. Before we go into an explanation as to when an inheritance may be taxable, let’s differentiate between an estate tax and a tax on inheritance. These are two separate and distinct types of tax that can sometimes be very confusing.

What is an estate tax?

Think of this as a two-tier level of taxation. When someone dies, an estate tax may be levied on the total value of what he owned at the time of his death. This includes cash, investments, real estate, and anything not covered by these three general categories.

Sometime prior to his death, the individual would have most likely named someone to be the executor of his will. As the executor, his responsibility would be to see that the terms of the will are followed, and also to be sure that the estate pays any taxes that may be due.

Any individual named in the will who will receive an inheritance, is not responsible for the payment of any estate taxes that may be due. However, before any assets are distributed to the beneficiaries, estate taxes must be paid, and this reduces the value of the estate that will be distributed.

Most states don’t follow the federal guidelines, and not all states have a tax on a deceased person’s estate. Nor do many of them impose a tax on inheritance.

On what estate value will you pay an estate tax?

As of the writing of this article, 2021, any estate that has a value that exceeds $11.7 million, will pay an estate tax on the amount that exceeds that base value. Keep in mind though, the $11.7 million applies to a single individual. For a married couple, the base value increases to $23.4 million.

Currently, twelve states and the District of Columbia impose an estate tax. The federal tax rate is progressive, just like the personal tax rates, and starts at 18% up to 39%. At that point, the tax is a flat 40% rate over $1 million. State estate tax rates vary, as do their base amounts where an estate tax is required.

What is an inheritance tax?

If you ask the question, is there a tax on inheritance, it depends on the amount and the state that you and/or the decedent lived in live in. It may also depend on the type of asset that you are inheriting. In 2021, six states have an inheritance tax , and for most of them, your relationship to the decedent decides if you pay the tax or not.

Keep in mind, however, that there is no federal tax on inheritance. The confusion begins when someone inherits an IRA, as an example. That type of inheritance is a taxable event. Depending on the relationship to the decedent, the IRA is distributed to the beneficiary, and taxes are paid when his personal tax return is filed. Bear in mind that this is not a tax on an inheritance.

If I sell inherited investments or real estate, do I pay tax?

Often times, when you receive an inheritance, it doesn’t come to you in a check or some other form of cash. You may receive stocks or mutual funds, real estate, or even art work. Normally, if you sell or otherwise dispose of them, you will have capital gains taxes to pay on your personal tax return.

What this means is, you will pay taxes on the gain on the sale, which is the difference in cost and the amount of the sale price. These taxes also confuse some individuals, but the real distinction is that they are not a tax on inheritance either.

Depending on when you sold the asset, you may not have to pay any capital gains taxes. When a person dies, all assets are re-valued as of the date of death. This gives the inheritor a stepped up in basis which becomes the new cost of the asset to be used if sold.

As an example, let’s use a parcel of real estate. The person who died paid $100,000 for his home many years ago. When he died, the home was appraised by the estate for $200,000. The person who inherited the home a few months prior, will use $200,000 as his cost basis.

If he sells the home in that short period of time for $200,000, there is no gain on the sale and no capital gains taxes to be paid. The step up in basis rules are very advantageous to the inheritor and has saved a lot of money for many individuals.

Summary

Hopefully, you have a better understanding on the differences between an estate tax and an inheritance tax. The estate of the deceased person pays the federal and state taxes if applicable. With an inheritance, the individual receiving the assets will have no federal inheritance tax, but may have to pay a tax to the state, if applicable.

Selling any of the assets that you inherited may trigger capital gains taxes, but these taxes are reduced because of the step up in basis. The inheritor gets a new basis on these assets. They are re-valued as of the day the person died, and the original cost to the decedent is not used.

The key point to remember is that none of the capital gains taxes or other taxes paid on the sale of inherited assets, represents a federal tax on inheritance.

Gust Lenglet
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