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Is That Inheritance Taxable?
Article Highlights:
- Estate Tax
- Estate Tax Exemption
- Fair Market Value at Date of Death
- Step up in Basis
- Community Property
- Deferred Untaxed Income
Sound bleak? Don’t worry, very few decedents’ estates ever pay any estate tax, primarily because the tax code exempts a liberal amount of the estate’s value from taxation; thus, only very large estates are subject to estate tax. In fact, with the passage of the Tax Cuts & Jobs Act (tax reform), the estate tax exemption has been increased to $11,580,000* for 2020 and will be inflation-adjusted in future years. That generally means that estates valued at $11,580,000* or less will not pay any federal estate taxes, and those in excess of the exemption amount only pay estate tax on the excess amount. Of interest, there are less than 10,000 deaths each year for which the decedent’s estate exceeds the exemption amount, so for most estates, there will be no estate tax and the beneficiaries will generally inherit the entire estate.
* Note that, as with anything tax-related, the exemption is not always a fixed amount. It must be reduced by prior gifts in excess of the annual gift exemption, and it can be increased for a surviving spouse by the decedent’s unused exemption amount.
Of course, once a beneficiary (also referred to as an heir) receives the inherited asset, any income generated by that property—be it interest from cash, rent from real estate, dividends from stocks, etc.—will be taxable to the beneficiary, just as if the property had always been the beneficiary’s.
Because the value of an estate is based upon the fair market value (FMV) of the assets owned by the decedent on the date of their death (or in some cases, an alternative valuation date six months after the decedent’s date of death, which is rarely used), the beneficiaries will generally receive the inherited assets with a basis equal to the same FMV determined for the estate. What this means to a beneficiary is that if they sell an inherited asset, they will measure their gain or loss from the inherited basis (FMV at date of death).
Example #2: Joe inherits his father’s home. Like other inherited property, Joe’s basis is the FMV of the home on the date of his father’s death. However, unlike the stock, the FMV of which could be determined from the trading value, the home needs to be appraised to determine its FMV. It is highly recommended that a certified appraiser perform the appraisal and that it be done reasonably close in time to the decedent’s date of death. This is frequently overlooked and can cause problems if the IRS challenges the amount used for the basis.
This FMV valuation of inherited assets is frequently referred to as a step up in basis, which is really a misnomer because the FMV can, under some circumstances, also be a step down in basis.
If the decedent was married at the time of death and resided in a community property state, and if the property was held by the couple as community property, the beneficiary spouse will generally receive a basis equal to 100% of the FMV of the property, even though the spouse will have only inherited the deceased spouse’s share.
Not all inherited assets received by the beneficiary fall under the FMV regime. If the decedent held assets that included deferred untaxed income, those assets will be treated differently by the beneficiary. Examples of those include inherited:
Roth IRAs – Qualified distributions are not taxable to the beneficiary.
Compensation – Amounts received after the decedent’s death as compensation for their personal services.
Pension Payments – These are generally taxable to the beneficiary.
Installment Sales – Sometimes taxpayers will structure sales, usually of real property, so that the buyer pays the seller for the purchase with interest over several years. This is referred to as an installment sale. Whoever receives an installment obligation as a result of the seller’s death is taxed on the installment payments the same as the seller would have been, had the seller lived to receive the payments.
This is just an overview of issues related to being the beneficiary of an inheritance. If you have questions related to the tax ramifications of a potential or actual inheritance, please give this office a call.
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Offices in Flemington, NJ and Califon, NJ
Our Mission: At Prestige Accounting Services Group (previously Prestige Wealth Accounting Group), we are on a mission to redefine the tax experience for individuals and small businesses. With a focus on personalized service, strategic planning, and expert guidance, we aim to empower our clients to succeed financially with confidence and ease.
Expertise in Action: With a wealth of experience and a team of dedicated professionals, we specialize in individual and small business tax preparation. While we excel in all areas of taxation, our passion lies in serving the unique needs of small business owners in New Jersey. We understand that small business taxation requires specialized knowledge and attention to detail, which is why we go above and beyond to ensure our clients receive the guidance and support they deserve.
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Why Choose Us?: What sets us apart from other New Jersey tax firms is our commitment to excellence and innovation in the field of taxation. We don't just prepare tax returns; we provide strategic insights, proactive planning, and actionable advice to help our clients achieve their financial goals. With a team of two CPAs, an EA, and an ERO, we have the expertise and resources to deliver exceptional service and results.
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