While there's no federal inheritance tax, a handful of states (as of 2019, Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania) still tax some assets inherited from the estates of deceased persons. Whether your inheritance will be taxed, and at what rate, depends on its value and your relationship to the person who passed away. The value of the assets for tax purposes are calculated on what's known as their cost basis.
- There's no federal tax on inheritances, but six states tax them based on the cost-basis value of the assets received.
- The cost-basis figure is usually the fair market value at the time the owner of the estate dies, or when the assets are transferred.
- If the assets dropped in value after you inherited them, you may instead choose a valuation date of six months after the date of death.
- Surviving spouses do not pay inheritance taxes, and descendants of the person who died rarely do so.
Determining Cost Basis on an Inheritance
Cost-basis calculations for estates differ from those used for other tax purposes. When used to calculate capital gains on assets you own, cost basis represents the original value of an asset for tax purposes, with a few adjustments. With assets you inherit, the cost basis is usually equal to the fair market value of the property or asset at the time of the decedent's death or when the actual transfer of assets was made.
Fair market value is the price that a property or asset would command in the marketplace, given that there are buyers and sellers knowledgeable about the asset and that a reasonable period of time is made available for the transaction to take place.
If the value of the assets has dropped since the date of death or of their transfer, the administrator of the estate can decide to use an alternative valuation date for the estate. This extends the valuation to six months after the date of death. Such a delay can serve to reduce the tax due on the inheritance.
You're able to wait to find out if such a reduction in fact occurs, since you can elect the alternative valuation as late as a year after the relevant tax return is due. Indeed, under estate law, the value of the estate must have dropped in value by the six-month mark in order to choose this option; otherwise, one of the regular valuation dates must apply.
Which Valuation Date to Choose
A few potential disadvantages apply to opting for the alternative date. For one, the timing must apply to all of the inheritance; you cannot pick and choose its application to particular assets. Also, the lower valuation it creates will in future form the basis for any capital gains you incur. You may, then, eventually be subject to a larger tax bill for capital gains than if you had chosen a higher valuation when you inherited the assets.
A final note: Some exceptions to these valuation rules may apply to assets related to farming or a closely-held business. Research these before you make any decisions around when and how to carry out a valuation.
Inherited assets qualify for long-term capital gains treatment, even if you sell them immediately after inheriting them.
Capital Gains on Inherited Assets You Sell
If you choose to sell assets you inherited, you do not escape tax liability. However, if you sell them quickly, you're subject to more favorable treatment for capital gains than is customary. No matter how long property or assets are actually held, either by the decedent or the inheriting party, inherited property is considered to have a holding period greater than one year.
Because of that, capital gains or losses are designated as long-term capital gains or losses for tax purposes. Even if you sell them immediately, you avoid the less favorable treatment typically given to assets that are held for less than a year, which are usually taxed at your normal income tax rate.
Exemptions From Inheritance Tax
Even in states that tax inheritances, family members are generally spared from tax, as are relatively small inheritances.
Surviving spouses are exempt from inheritance tax in all six states. Domestic partners, too, are exempt in New Jersey. Descendants pay no inheritance tax except in Nebraska and Pennsylvania.
Both the thresholds at which inheritance tax kicks in and the rates charged typically vary by relationship to the decedent. Threshold amounts vary between $500 and $40,000 and the tax rates range between 1% and 18%. The specific rules by state are complex. Generally, though, the stronger your familial relationship to the decedent, the less likely it is that you'll have to pay tax, and the lower the rate.
The thresholds are for each individual beneficiary, and the beneficiary must pay the tax. A state may charge a 13% tax on your inheritances, for example, if they're larger than $10,000. Therefore, if your friend leaves you $20,000 in his will, you only pay tax on $10,000, for a bill of $1,300. You'd be required to report this information on a state inheritance tax form.