Tax Issues with Inheriting
For tax purposes, inheriting property is generally advantageous. When a person dies (the decedent), they will usually designate an executor in their will to manage the estate and distribute property. If a person dies without a will or an executor is not named in the will, then the court will appoint an administrator to act and do as an executor. An executor will collect the decedent's assets, pays creditors and distribute the remaining assets to heirs. In general, cash, stocks and bonds, real estate and most property inherited will not be taxed to the beneficiary upon receipt. An IRA, however, may be taxed to the beneficiary when inherited. Some of the tax consequences of inheriting property are discussed as follows:
- Basis of Property--The basis of inherited property is generally its fair market value on the date of the decedent's death. The executor, however, can choose to use the fair market value on the "alternate valuation date." The alternate valuation date is the day six months after the decedent's death.
- Real Estate (Home) -- The basis of inherited real estate is the fair market value on the date of the owner's death or an alternate valuation date (if it is chosen by the executor or representative). If the surviving spouse inherits the family home, he/she qualifies for the up-to-$500,000 exclusion if the home is sold no later than the second anniversary of the spouse's death and either spouse meets the ownership and use requirements. Otherwise, the surviving spouse is limited to an exclusion of $250,000, unless the home was sold in the year of death. A loss on the sale of a personal residence is generally not deductible; however, a capital loss may be allowed on the sale of inherited property in certain circumstances.
- IRA-- A spouse who inherits an IRA and takes a distribution as a lump-sum will pay income tax in the year of distribution, but no penalty is due even if the inheriting spouse is under age 59 1/2. If the inheriting spouse is the sole beneficiary of the IRA, then the spouse can transfer the inheritance to a new or existing IRA in their name. In this case, the surviving spouse cannot take a distribution before age 591/2 without incurring a penalty. A non-spouse who inherits an IRA will have to determine basis (that is whether or not the decedent's contributions were or were not deducted). If the decedent made nondeductible contributions, then there is a basis that won't be taxed when distributed. A heir may be able to deduct the estate tax resulting from distributions from an IRA that is income in respect of a decedent. Distributions from Roth IRAs are tax-free. Earnings of Roth IRAs may be taxable when distributed. Earnings that are distributed from a Roth account that has been open for at least five years after decedent's death are tax-free.
- Income in Respect of a Decedent ("IRD")--IRD is defined as income that was not taxed in decedent's final return, but that decedent would have received if he/she had not passed away. This income could be wages, rents, partnership income that was due to the decedent, but not yet paid. IRD is reported in the decedent's estate tax return, but only becomes taxable for income tax purposes when received by the beneficiary or estate. An income tax deduction is allowed the beneficiary/estate for estate taxes paid on the income. The deduction is taken on Schedule A of tax return as a miscellaneous itemized deduction. It is not subject to the 2% of adjusted gross income floor. Beneficiaries who are required to include IRD on their tax returns, should request a copy of the estate's tax return (form 706) from the executor. The return will have the information needed to determine your estate tax deduction.
- Estate Income Tax Returns--Income earned on estate assets must be reported on income tax returns by the estate. This obligation to file and report exists until all assets have been transferred from the estate to beneficiaries. An estate is required to file Internal Revenue Service (IRS) form 1041 if its income exceeds $600. It will be the executor who has the obligation to file returns. If the income of the estate is distributed to beneficiaries, the beneficiaries must report the income on their tax returns. If, however, the income is not distributed, then the estate must report and pay the income tax. If the income is initially retained by the estate without tax being paid and then later distributed to beneficiaries, then the beneficiaries can still be liable for the tax, up to the amount of the estate's property. In the final year of the estate, the beneficiaries will generally have to report taxable income and pay the tax. Attorney fees and other expenses paid by the executor during the last year of the estate can be used as a deduction against income earned during the same year( if they have not been already claimed on the Estate's tax return). Estate's are required to issue K-1s to beneficiaries that report the amount of income and deductions reportable by them.
- Charitable contributions--Beneficiaries who inherit property that they later donate to a qualified charity are entitled to a deduction. For purposes of this deduction, the fair market value of the donated property is its value on the date of the decedent's death.
- Life Insurance--Proceeds from a life insurance policy are generally non-taxable.
Bowman Law Firm Gene M. Bowman, Attorney