If you have been named a beneficiary in a loved one or friend’s will, you may be wondering whether you have to report the inheritance on your tax return. While you don’t have to pay taxes when your inheritance comes into your hands, you may have to pay taxes if the value of the inherited property increases after you acquire it.
Your Inheritance and Federal Inheritance Tax
When you receive an inheritance, you don’t have to pay federal tax on it. Unless the combined gross assets and previous taxable gifts exceed a particular amount (for 2017, this exemption was $5,490,000, and for 2018 it's twice that), no estate tax return reporting the inheritance is required. This means only large estates are subject to estate tax.
If you receive your inheritance as cash, the money comes to you on a tax-free basis. This is probably the easiest way for you to receive your share of the estate, since you receive the money directly. Once you have access to the funds, any interest earned on the money is taxable as any other money normally would be.
Some inheritances come in the forms of stocks or mutual funds. These pass to you by transferring ownership from your deceased loved one or friend to your name. Once the transfer is complete, you are free to do what you wish with them.
You may choose to hold on to these investments and let them accumulate in value over time, keeping in mind that they will increase and decrease in value with changes to the market. You do not have to pay any tax on the stocks or mutual funds when you receive them. However, if your investments pay dividends, you pay taxes on these amounts. If you decide to sell them, you pay capital gains tax if the investments have increased in value from the time the title was transferred to your name rather than from when the deceased person acquired them.
When you inherit property, such as stocks, mutual funds or even a house, the fair market value of the property is determined based on the date your loved one or friend died. That figure is important when you sell the property. It’s the price at which the property would have been exchanged between a willing buyer and a seller, with neither person being pressured to make a decision, and both of them knowing the facts about the property. The fair market value can’t be determined by the price the property would fetch at an estate sale, which implies that the executors are willing to take a lower price than usual to convert the property to cash.
As long as you own inherited property, you are only responsible for paying tax on any dividends and interest. If you decide to sell or dispose of the property, you pay capital gains tax if the value of the property increased during the time you owned it.
If your loved one or friend had sold the property during his lifetime, the capital gains tax would have been calculated based on the amount she paid for the property. Since you received it as an inheritance, the date of purchase is moved up. This is a benefit to you because the property does not have had as much time to increase in value since your loved one or friend’s passing. You end up paying a lower amount of capital gains tax than if it had been calculated based on the original purchase date.
When you sell property that you have owned for one year or less and make money on the deal, it is considered a short-term capital gain. If you hold on to the property for more than one year before you sell it for a profit, you have a long-term capital gain.
This is an instance where being patient works in your favor. Short-term capital gains are taxed at your regular tax rate. Long-term capital gains are taxed at a lower rate. It’s to your advantage to delay the sale for at least a year and a day, if possible, to save money on your taxes.
Use Schedule D on Form 1040 to calculate the amount of your capital gain for your federal income tax return. Part I of the form is used to report short-term capital gains and Part II is where you report the details of long-term capital gains. You'll be asked to fill out the proceeds (sale price) for the property you sold during the year, along with its cost. This would be the property's fair market value as of the date you acquired it. Subtract the cost from the oroceeds to determine the amount of your capital gains on your inherited property.
Part III of the form is a summary. Follow these instructions carefully to determine where to report your capital gain on your federal income tax return.
Exceptions for Inheriting from Certain Expatriates
There is one exception to the rule about an inheritance being a tax-free gift from the deceased person's estate passing to a beneficiary. If the person who left you the inheritance was a “covered expatriate,” you are, unfortunately, potentially on the hook for paying tax.
A covered expatriate is someone who was either a former U.S. citizen or a long-term resident who has renounced his citizenship or residency. The person must meet these criteria: a net worth of $2 million or more as of the date of expatriation or termination of residency, average annual net income tax for the five years before the date of expatriation or termination of residency is more than an amount specified by the IRS. The amount was $162,000 in 2017 and $165,000 in 2018. They also must have failed to certify on IRS Form 8854 that all U.S. federal tax obligations have been fulfilled for the five years preceding the date of expatriation or termination of residency.
The rules are complicated, and it can be worth consulting an accountant or tax lawyer if you need to deal with this situation as either an expatriate or an expatriate's heir or potential heir.
2018 Tax Law and Your Inheritance
As of tax year 2018, the federal estate tax limit is doubling to $11,180,000. Generally estates valued at less than that do not have to pay the IRS inheritance tax.
Long term capital gains rates are remaining at 0 percent, 15 percent or 20 percent, depending on your total income, while ordinary income and short term capital gains rates are generally decreasing for each income level, which could benefit you if you sell inherited property.
2017 Tax Law and Your Inheritance
As of the 2017 tax year, estates under $5,490,000 are generally not subject to federal estate tax.
Long term capital gains are taxed at 0 percent, 15 percent or 20 percent based on your income, while ordinary income and short term gains are taxed under a higher tax bracket system than in 2018 and subsequent years.
- IRS.gov: Estate Tax
- IRS.gov: Expatriation Tax
- IRS.gov: FAQs on Estate Taxes
- Financial Web: Determining Fair Market Value on Investment Property
- IRS.gov: Schedule D
- IRS: What's New - Estate and Gift Tax
- Forbes:New: IRS Announces 2018 Tax Rates, Standard Deductions, Exemption Amounts And More
- Hodgen Law: Gifts, Bequests, Inheritances and Expatriation
- DMCL: Thinking of Leaving the US? Know the Expatriation Tax Rules
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