People often have questions about the way that inheritances are taxed, and many of them assume that you would have to report a bequest when you file your income taxes. In fact, even though it may be a bit surprising, this is not the case at all.
Inheritances are not considered to be taxable income by the Internal Revenue Service or state tax agencies. This includes direct inheritances and insurance policy death benefit payouts, at least for now.
Another piece of good news pertains to the capital gains tax. If you inherit assets that appreciated during the life of the decedent, you would get a step-up in basis. That means your tax cost becomes the fair market value at the time you inherit the asset. That means the former owner’s capital gains liability is erased. You would not be responsible for that appreciation.
If the assets continue to appreciate after you inherit and you sell the asset at a later date, you would be on the hook for capital gains taxes on any gain or profit you realize.
Federal Estate Tax
There is a federal estate tax in the United States, and it packs a heavy punch with a 40 percent maximum rate. Fortunately, most American families are not impacted by this tax, because there is an estate tax exclusion that allows you to transfer a certain amount tax-free.
At the time of this writing in 2020, the federal estate tax exclusion is $11.58 million. There are annual adjustments to account for inflation, so the figure will be somewhat higher in 2021.
We should point out the fact that this number is not permanently etched in stone. It can be changed via legislative mandate, and it was actually doubled when a tax relief bill package was enacted at the end of 2017. In fact, current law provides the exclusion reverts back to $5 million adjusted for inflation on January 1, 2026. Be aware of this tripwire.
High net worth individuals do not have to be concerned about taxes on inheritances that they leave to their spouses. There is an unlimited marital deduction that can be used to transfer any amount of money in a tax-free manner to a spouse that is an American citizen.
While we are on the subject of spouses, the estate tax exclusion has been portable since 2011. This means that a surviving spouse would be able to use the exclusion that would have been allotted to their deceased spouse.
Federal Gift Tax
When you hear about the estate tax, you would logically consider lifetime gift-giving as a way to get around this levy. People used to do this shortly after the estate tax was enacted in 1916, but a gift tax was enacted in 1924 to close this window of opportunity.
It was repealed a couple of years later, but it was reenacted in 1932. The gift tax has been in place since then, and it is now unified with the federal estate tax. As a result, the exclusion is a unified exclusion that applies to lifetime gifts in excess of the current $15,000 annual exclusion. Those larger gifts require filing a 709 U.S. Gift Tax return and are charged against your lifetime exclusion.
State-Level Estate Taxes
There are a number of states that have state-level estate taxes. In these states, the exclusions are typically lower than the federal exclusion, so a person that is federally exempt could be exposed to a state estate tax.
We have offices in Kansas and Oklahoma, and there are no estate taxes in these states. However, if you own valuable property in a state that does have an estate tax, it could be a factor for you and your family.
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This valuable tool has been carefully prepared to help you understand the process more thoroughly. We urge you to take the time to go through it, and you can visit our worksheet page to gain access to your copy.