Aside from the taxes that an estate pays, beneficiaries may be responsible for paying taxes on the property that they inherit. Tax liability attaches to and moves with estate assets. Therefore, beneficiaries will be responsible for any tax liability not already paid by the estate.
The Decedent's Income
If a beneficiary receives income that would have otherwise gone to the decedent, they must pay tax on the money. For example, Eri completes yard work for a neighbor and dies before the neighbor can pay him. If the neighbor pays Eri’s daughter, Ida, after the estate is closed, Ida will need to report that payment as income on her personal income tax return. (Had the neighbor paid the debt while the estate was still open, it would have been reported as the estate’s taxable income.) This income is sometimes known as income "in respect of the decedent."
Retirement Accounts, Life Insurance, and Savings Bonds
Generally, beneficiaries do not pay income tax on money or property that they inherit, but there are exceptions for retirement accounts, life insurance proceeds, and savings bond interest. Money inherited from a 401(k), 403(b), or IRA is taxable if that money was tax deductible when it was contributed. Most contributions to these types of retirement plans are tax deductible, but if the account contains non-deductible contributions, the beneficiary may want to consult a tax expert to determine the tax owed. A beneficiary may be able to open an "inherited IRA" and pay the owed taxes over a period of time. Surviving spouses who inherit 401(k)s, 403(b)s, or IRAs may be able to roll the money over into their own retirement account to defer the tax.
Beneficiaries who inherit money from Roth IRAs will not need to pay tax on most withdrawals because the contributions would not have been tax deductible. A beneficiary also will not need to pay taxes on any money that the contributions generate so long as the account is at least five years old.
A beneficiary of a life insurance policy generally will not need to pay taxes on the proceeds, but they may need to pay taxes if the proceeds include interest (this is common if the payments are made in installments) or if the policy was transferred to the beneficiary for cash or other valuable consideration. Similarly, a beneficiary who inherits U.S. Savings Bonds may need to pay taxes when the bonds mature or are redeemed if the original owner of the bonds deferred the tax.
The federal government does not impose an inheritance tax, but some states do. Beneficiaries may owe state inheritance taxes based on the value of what they inherit and their relationship to the decedent. Tax may be due not only to the state in which the decedent lived, but also to the state in which the inherited real estate is located. The beneficiary’s place of residence has no effect on the tax. For example, an Ohio beneficiary may owe inheritance tax in Iowa (an inheritance tax state) if the decedent lived in Iowa, but an Iowa beneficiary will not owe inheritance tax in Ohio (a non-inheritance tax state) if the decedent lived in Ohio.
Tax Basis and Capital Gains Tax
An individual will generally owe capital gains tax when they sell a valuable asset. An item’s tax basis is used to determine the taxable gain or loss on the item. An item’s tax basis is usually its purchase price. For example, Ned purchases a house for $100,000. He later sells the house for $175,000. His tax basis is $100,000, so his taxable gain is $75,000 ($175,000 - $100,000). When a beneficiary inherits property, a special rule converts the tax basis of the property to the value of the property as of the date of death. This rule is sometimes known as the "stepped-up basis" rule. Using the previous example, if Ned died before selling the house, and the house was valued at $165,000 at the time of his death, the tax basis of the house would be $165,000. If Ned leaves the house to Nora, who later sells it for $175,000, her taxable gain is only $10,000.
Spouses in community property states have an additional advantage under the stepped-up basis rule. In community property states, spouses each own a one-half share of their community property. When one spouse dies, the other inherits that spouse’s one-half share, and both halves receive a stepped-up basis.
Surviving Spouse Capital Gains Exclusion
Couples may be entitled to a $500,000 capital gains exclusion when they sell their primary residence under certain circumstances. Single taxpayers are only entitled to a $250,000 exclusion, but a surviving spouse may be entitled to claim the full $500,000 in the two years following the spouse’s death.