Article Highlights:

  • Bank Accounts
  • Capital Assets
  • IRA or Other Qualified Retirement Plans
  • Life Insurance Proceeds
  • Annuities and Installment Sale Notes
  • Estate Income Tax Returns and K-1s

If you have received an inheritance or anticipate receiving one in the future, this article may answer many of your questions. The process of claiming an inheritance can be quite complex, and it helps to understand the basics and be aware of potential tax liabilities.

An inheritance is generally received after all applicable taxes (on estate returns, estate or trust income tax returns, decedent’s final tax return, decedent’s back taxes, etc.) 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 results for a beneficiary will generally be the same. Inherited items on which the decedent had already paid taxes and upon which the estate tax (if any) has been paid will pass to the beneficiary tax-free. On the other hand, items of income that had not previously been taxed to the decedent and 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 and up to the time at which the funds are paid to the beneficiary. Out of the $25,375 the beneficiary receives, the $25,000 is tax-free, but the $375 is taxable as interest income.
  • Capital Asset -The basis for gain or loss from the sale of an inherited capital asset, such as stock, real estate, collectibles, etc., is generally based on the value of the asset at the time of the decedent’s death. That is one reason why qualified appraisals are so important.

    To explain this further, let’s 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 is neither gain nor loss and the $15,000 is tax-free to the beneficiary. 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 longer than one year are generally taxed substantially less than those held for a shorter period of time. However, for inherited property, the beneficiary receives long-term treatment immediately, whether or not the decedent or the beneficiary had held it for more than one year. If there are expenses associated with selling the asset, then those expenses are deductible in figuring the gain or loss. If the heir in this example held onto the land and did not sell it, he has no income or loss to report just because he inherited the land; the value of the land when he passes away will determine the amount to be included in his estate, his heirs will receive it at that value, and the cycle will start over.

  • IRA or Other Qualified Retirement Plan – Suppose the decedent had a traditional IRA account and the distributions from that account were taxable to the decedent. If you inherited that account, the distributions would be taxable to you as the beneficiary. Why? Because the decedent had never paid taxes on the income that went to fund the traditional IRA and therefore you, the beneficiary, would be stuck with the tax liability. The good news is that there are options for taking the income over a number of years that 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 property he previously sold, the decedent’s basis will be tax-free, but the heirs will be obligated to pay tax on any amount received in excess of the decedent’s basis. For an annuity, the decedent’s basis would be what he 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, which 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 before the assets are distributed to the heirs. Each heir will generally receive a form called a Schedule K-1 (1041). It will include that heir’s share of income and must be included on the heir’s individual tax return. Although infrequent 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 herein. Please call this office if you are or expect to be a beneficiary and need assistance with the tax implications of an inheritance.

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