An inheritance can be a windfall in several ways the inheritor not gets cash or a piece of property but does not have to pay income tax on it. Somebody who inherits a $500,000 bank account does not have to pay any tax on that amount. It does not matter how the property passes to the inheritor. Whether the property passes under the terms of a will or trust, or the inheritor was a designated beneficiary (for instance, a payable-on-death bank account), it isn’t taxable income. In fact, receiving an inheritance from someone who has passed away is not a taxable event, but how much tax you will pay when you take money out of that asset for instance by selling a stock or distributing money from a retirement account depends on the asset itself. When an heir will get an asset, the property value must be determined.
In general, this new, adjusted value (called the adjusted basis) for income tax purposes is the current fair market value (FMV) of property as reported on the estate tax return of the decedent. This can be either the FMV at the decedent’s date of death or the alternate valuation date (6 months after the death’s date) if that was selected. This new basis is referred to as a step-up basis for the heir because the heir steps up from the old, low basis to the new, high basis. The basis is essential because it determines how much tax you will have to pay when you sell. The property holding period is deemed to be a long-term investment (and it is subject to long-term low capital gains rates). This applies irrespective of how long you hold the property before selling it.
If you are inheriting an IRD asset
Assets considered income in respect of a decedent (IRD) don’t qualify for the step-up in basis adjustment. IRD assets will result when the decedent opted when alive to defer paying income tax into the future. Common instances of IRD assets are:
- Qualified retirement plans like 401k and 403b plans
- IRAs
- Annuities
- Savings bonds
- Installment notes
As an heir, your basis will be equal to the basis of the decedent in the asset not the value of the asset at the death of the decedent. This makes sure that the government can collect income tax due on the deferred income.
When you receive life insurance proceeds
If you are the beneficiary of a life insurance policy on someone who has passed away, as a general rule, the death benefit paid to you won’t be subject to income tax. The exception is if the decedent owned the policy first and then gave you the policy (that is made you the policy’s owner) in exchange for valuable consideration (that is you gave the decedent something in exchange for getting the policy or there was an economic reason behind transferring the policy). This’s known as the transfer for value rule.
Tax on Income Generated by Inherited Property
when a beneficiary will get an asset, any income from that asset is taxable. For instance, if you inherit a home and rent it out to tenants, you must pay income tax on the rent payments you receive. Likewise, if you inherit a bank account, you do not pay income tax on the funds in the account, but if they begin earning interest, the interest payments are your taxable income.
Tax on Life Insurance Proceeds
If a beneficiary will pay tax on the proceeds of a life insurance policy or not, all depends on whether the proceeds are being paid in installments with interest or in a lump sum. If they’re paid in a lump sum, they aren’t taxed. If they’re paid in installments over many years, the part of every installment that constitutes interest (instead of principal) is taxable income every year.
Capital Gains Tax on Appreciated Property
If you inherit property that appreciates in value, the amount of the gain is taxable. To calculate accurately how much the property has gained in value, you will need to determine what is known as the basis in the property. Usually, for tax purposes, the basis will simply be how much you originally paid for the property. However, when you inherit property, you get the benefit of what is known as a stepped-up basis, which means that rather than being taxed on the whole gain from the moment of the deceased person’s buying, you are taxed on the gain from the deceased person’s date of death.
