I just inherited money, do I have to pay taxes on it?

May 26, 2020 by Carolyn Richardson, EA, MBA
Inheritance on top of money

Like so much in tax law, the answer to this question is “it depends.”

Generally, when you inherit money it is tax-free to you as a beneficiary. This is because any income received by a deceased person prior to their death is taxed on their own final individual return, so it is not taxed again when it is passed on to you. It may also be taxed to the deceased person’s estate. Taxing it to the beneficiary and the estate would result in double taxation, and usually the tax laws of the United States try to minimize double taxation. So, if your mom dies and has $50,000 in her checking account or you find it stuffed under her mattress, you can receive that money and it’s not income to you (providing you are a beneficiary of her estate). This is true whether you inherit the money from a relative or a friend. There is no requirement for you to be related to the person who leaves you the inheritance.

However, not all money received from the deceased is tax-free. For example, if tax deferred retirement accounts like IRAs or 401(k)s are owned by the decedent and are distributed to their beneficiaries, this money would be taxable to the beneficiary in the year they receive it. This is because these funds have not been previously taxed. If the beneficiary is a spouse, they have the option of designating the retirement account as a beneficiary IRA or treating it as their own retirement account (or both). However, any other beneficiary – with a few exceptions – generally must now withdraw all of the IRA funds within ten years of the date of death of the original account owner, if the account owner died after December 31, 2019 (different rules apply to account owners who died before 2020). Non-spouse beneficiaries can choose to withdraw a lump sum amount or take periodic withdrawals as long as all the money is removed from the account within the required time frame. The distributions cannot be rolled over to the beneficiary’s own retirement account (unless they are the spouse). Regardless of the relationship to the deceased, the beneficiary is required to take required minimum distributions (RMDs) each year if the decedent was required to withdraw RMDs when they died. RMDs are required for many retirement accounts in the year the account’s owner turns age 70.5 if they reach that age in 2019, or 72 years if the owner turns 70.5 in 2020 or later. The beneficiaries must also take out at least as much as the RMD during the year. While these distributions are subject to income taxes, they are not subject to the early 10% withdrawal penalty regardless of the age of the beneficiary.

Likewise, when a decedent leaves income-producing property to a beneficiary and that property generates income, the income from that property is taxable to the beneficiary. For example, your brother dies and leaves you a rental property that belonged to him. The income from that rental property would be taxable to you just like it was taxable to him. This is because the title of the rental property and all its rights and privileges have been passed to you as his beneficiary. It is no different than if you had gone out and bought the rental property yourself. That being said, you may receive a “step-up” in the basis of the rental property, so if you decide to sell the rental property after inheriting it, the gain on the property sale would be reduced because of the stepped-up basis. A step-up in the basis means that the property can be valued at the fair market value on the date that your brother passed away or, alternatively, at a date six months later. (The “alternate valuation date” can only be used if the brother’s total estate is large enough to file an Estate return Form 706, and if the alternate valuation date will decrease the value of the gross estate.) This means that if your brother’s rental property cost him $100,000 but was worth $400,000 on the day that he passed away, you would use the $400,000 value when you turn around and sell the property. If the property sold for $410,000, you would only recognize a $10,000 gain on the sale of the property rather than a $310,000 gain. So, in a way, you received $300,000 from your brother “tax free.”

What about inheriting such things as stock? If you inherit stock from another person, it is treated similarly to the rental property example in the previous paragraph. While any income produced from the stock after the owner died would be taxable to the beneficiary, such as dividends, the underlying stock itself is revalued to the fair market value as of the date the original owner passed away. If the beneficiary sells the stock, the calculation of the gain or loss on the stock sale would depend on that new fair market value. Therefore, if the stock has increased in value since the date of death, the beneficiary would have to recognize a capital gain on the sale of the stock. Likewise, if the value decreased since the date of death, the beneficiary would have a capital loss. What about property or money held by the decedent in a living trust? Living trusts are a popular legal vehicle with which to avoid an expensive probate of an estate. Many people have these set up to hold their personal residence or other assets. Because a living trust is a disregarded entity for federal tax purposes, any stock, other property, or money held in the living trust is treated as belonging to the decedent before they pass away. Once the grantor (the person who set up the trust and owned the assets in it) of the trust dies, the assets within the trust now belong to the trust and they can generate income. If the income is not distributed to a beneficiary, the trust pays the tax. The beneficiaries may also be taxed on any income from the trust on their individual tax returns, depending on the type of income generated.

Estate and trust laws can be complex, and as always if you are not certain what to do when someone dies and leaves a trust or sizable estate, you should seek the advice of a competent professional such as an accountant or attorney who specializes in this area of tax law. Most estates fall below the value that would require an estate return, however, so if you should happen to inherit some money, enjoy it!

SEARCH

 

Carolyn Richardson, EA, MBA
Learning Content Managing Editor

 

Carolyn has been in the tax field since 1984, when she went to work at the IRS as a Revenue Agent. Carolyn taught many classes at the IRS on both tax law changes and new hire training. In 1990, she left the IRS for a position at CCH, where she was a developer on both the service bureau software and on the Prosystevm fx tax preparation software for nearly 17 years. After leaving CCH she worked at several Los Angeles-based CPA firms before starting at TaxAudit as an Audit Representative in 2009. Carolyn became the manager of the Education and Research Department in 2011, developing course materials for the company and overseeing the research requests. Currently, she is the Learning Content Managing Editor. 


 

Recent Articles

Mailing a Letter
If you choose to mail in your tax payment to the IRS or state, I recommend mailing it via certified return receipt or priority mail so that you can track it.
lady working with 3 binders
When operating a business, the last thing you want to worry about is being audited by the IRS or a state agency. Record keeping should be a high of a priority.
house
The IRS generally considers your primary residence to be the home where you spend the most time, but also looks at numerous other factors.
Tax Gap written on a Note
The tax gap is the difference between what the government actually collects in taxes versus what they should have collected to cover the real tax liability.
This blog does not provide legal, financial, accounting, or tax advice. The content on this blog is “as is” and carries no warranties. TaxAudit does not warrant or guarantee the accuracy, reliability, and completeness of the content of this blog. Content may become out of date as tax laws change. TaxAudit may, but has no obligation to monitor or respond to comments.