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A common question that comes up when I speak with my estate planning clients or the beneficiary of an estate or trust is whether or not the beneficiary will have to pay any taxes on their inheritance.

Before this question can be answered, the beneficiary needs to understand that the term “taxes” actually encompasses three different types of taxes:

  1. income taxes,
  2. inheritance taxes, and
  3. estate taxes.

Whether or not your inheritance will be subject to inheritance taxes, estate taxes and/or income taxes will depend on many factors, so let’s tackle each of these types of taxes separately.

Here’s what you need to know about how you might be taxed on an inheritance:Income Taxes

Good news! An inheritance is not counted as part of your income for tax purposes so you won’t have to report your inheritance on your state or federal income tax return.

However, the property that you inherit may have built in income tax consequences. For example, if you inherit a traditional IRA or 401(k), then you will have to include all distributions you take out of the IRA or 401(k) in your ordinary federal income, and possibly your state income, during the year in which you take the distributions.

Also, if you inherit real estate or any stocks that are held outside of an IRA or 401(k), then in the year when you sell the real estate or stock you may incur capital gains taxes based on the difference between the inherited value of the property (which receives a “stepped up basis” as of the date of death) versus the sales price that you receive.

The capital gains tax kicks in any time a gain is achieved. So, if you buy a dilapidated house to renovate with plans to immediately sell it, the amount of money over the original purchase price would be subject to the capital gains tax.

Inherited assets that appreciated during the life of the benefactor would get a step-up basis. This means that the value of the inherited asset would be subject to capital gains tax from when you inherited them. Good news! You would not be responsible for the gains that took place during the life of the person who left them to you. The key here is to understand that if you do realize a gain in the future, you will be responsible for the capital gains tax from the moment you acquired the asset.

For example, if you inherit a house that is valued at $100,000 on the decedent’s date of death but you turn around and sell the house for $150,000 a few years later, then you will owe capital gains taxes on $50,000.

So, there you go. You should now have a good idea about whether the money you plan to leave your loved ones will be taxed.  Check in with us next Tuesday, and we will and I will teach you about Inheritance and Estate Taxes.

The good news is that there are legal methods for reducing your tax burden if you are subject to them. We invite you to call us, your Will and Trust attorneys at 305.707.7126 to schedule an appointment where we can help you create an estate tax plan that best meets your needs.