It’s my annual “Taxes from A to Z” series! For the series, I’ll focus on terms that you might see on your tax forms and statements but not necessarily in the headlines. If you’re wondering whether you can claim wardrobe expenses or whether to deduct a capital loss, this is one series you won’t want to miss.
I is for Inheritance.
It’s always a good feeling when you get “free money” in the form of an inheritance or gift – until you start to worry that maybe it’s not so free.
Here’s the good news: in most cases, property you receive as an inheritance or gift is not included in your income for federal income tax purposes.
If property you receive as an inheritance or gift produces income (including interest, dividends, rents, and royalties), that income is taxable to you. That includes property that may be paid, credited, or distributed to you as part of a trust or estate even if that income isn’t directly paid to you. Similarly, if you receive property that would be wholly or partially taxable in the hands of the decedent, like a pension or an individual retirement arrangement (IRA), it will also be taxable to you (in whole or in part).
If property you receive as an inheritance or gift appreciates in value, you will be subject to capital gains tax on the appreciation when you sell, transfer or otherwise dispose of the property. Similarly, if property you receive as an inheritance or gift depreciates in value, you will be subject to capital losses on the difference when you sell, transfer or otherwise dispose of the property.
For more on realized capital gains and losses, click here.
And there’s more good news: property that you receive as an inheritance receives a “step up” in basis as of the decedent’s date of death. Here’s an example. Let’s say that your grandfather bought stock at $10/share. Let’s also say that on the day he died, it was worth $100 and it was worth $105 a week after his death.
- If your grandfather had sold the stock just before he died, that stock would have been subject to capital gains tax on $90 ($100 selling price less $10 cost basis).
But if he held onto it and upon his death, it is transferred to you, your new basis in the stock is $100: the basis was “stepped up” to the date of death value.
- If you sold the stock on the same day, there’s no capital gains tax payable ($100 selling price less $100 cost basis).
- If you sold the stock the week after, you’d pay capital gains tax on $5 ($105 selling price less $100 cost basis). Even better? The capital gains tax rate for inherited property is considered long-term – even if you only held it for a minute.
The news isn’t quite so great for property received as a gift. The basis for gifted property is the same as the basis in the hands of the donor. So, in our example, if your grandfather gave you the stock instead of leaving it as an inheritance, your basis would be the same as his had been ($10). If your grandfather had sold the stock before he died, that stock would have been subject to capital gains tax on $90 ($100 selling price less $10 cost basis). And sorry, unlike with an inheritance, with a gift, there’s no automatic “skip” ahead to long terms capital gains treatment: the normal rules apply in this case.
For more on basis, click here.
You knew there had to be some bad news. And here it is: while most inheritances are free from income tax, they may be subject to federal estate tax (you can find the 2016 exemption amounts here) or local inheritance taxes. Be sure to check with a legal professional before assuming you’re in the clear.
