In reality, the vast majority of estates are too small to be charged federal estate tax, which, as of 2020, applies only if the assets of the deceased person are worth $11.58 million or more. And most states have neither an estate tax, which is levied on the estate itself nor an inheritance tax, which is assessed against those who receive an inheritance from an estate.
A handful of states—Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania—still tax some assets inherited from the estates of deceased persons; a dozen states plus the District of Columbia continue to tax estates. Maryland collects both.
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 is calculated on what's known as their cost basis.
Though both are colloquially called "death taxes," inheritance taxes and estate taxes differ. An estate tax is levied on the value of the decedent's estate (all real and financial assets); an inheritance tax is levied on the value of inheritance from the decedent to a beneficiary.
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 (FMV) 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 property or an asset would command in the marketplace, given that there are buyers and sellers who know 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 alternate 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 select 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.
- There's rarely a 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; direct descendants rarely do so.
Which Valuation Date to Choose
A few potential disadvantages apply if you opt 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 the 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.
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 about when and how to carry out a valuation.
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 in each 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. Bear in mind that taxation applies only to the amount of the inheritance that exceeds the exemption. 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.