You could potentially be liable for three types of taxes if you've received a bequest from a friend or relative who has died: an inheritance tax, a capital gains tax, and an estate tax. An inheritance tax is a tax on the property you receive from the decedent. A capital gains tax is a tax on the proceeds that come from the sale of property you may have received. And finally, an estate tax is a tax on the value of the decedent's property; it's paid by the estate and not the heirs, although it could reduce the value of the inheritance.
Taxes at the Federal Level
The Internal Revenue Service (IRS) really only cares about any capital gains tax you might end up owing. The federal government doesn't impose an inheritance tax, and inheritances generally aren't subject to income tax. If your aunt leaves you $50,000, that's not considered income so the cash is tax-free—at least as far as the IRS is concerned.
State Inheritance Taxes
You probably won't have to worry about an inheritance tax, either, because only six states collect this tax as of 2019: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. If the decedent lived or owned bequeathed property in any of the other 44 states, you can collect your gift free of an inheritance tax—even if you live in one of these six states.
Property passing to a surviving spouse is exempt from inheritance taxes in all six of these states, and only Nebraska and Pennsylvania collect inheritance taxes on property passing to children and grandchildren.
You still might not owe an inheritance tax even if the decedent lived in one of the six states that have one, depending on your relationship to them.
State Income Taxes and Federal Income Taxes
You won't have to report your inheritance on your state or federal income tax return because an inheritance is not considered taxable income. But the type of property you inherit might come with some built-in income tax consequences.
For example, if you inherit a traditional IRA or a 401(k), you'll have to include all distributions you take out of the account in your ordinary federal income, and possibly your state income as well.
The Capital Gains Tax
This tax is applied to the difference between the value of an asset and the amount you sell it for. If you sell it for less than its value, this is a capital loss and no tax is due. If you sell it for more than its value, however, you'll be taxed on the gain.
Fortunately, the long-term capital gains tax rate is typically kinder than the tax brackets that individuals are subject to on their incomes, and inheritances qualify for the long-term rate. Plus, your inheritance receives a "stepped-up basis" to the date of the decedent's death as well.
For example, you might inherit a house that's valued at $250,000 on the decedent's date of death. You then sell the property for $275,000 a few years later. You would owe long-term capital gains tax on $25,000.
Even if the decedent purchased the property decades ago for $100,000, your gain isn't calculated using this number. It's stepped up to the value of the property as of the date of death, which typically results in less of a taxable profit—$25,000 as opposed to $175,000 using a sales price of $275,000 in this scenario.
State Estate Taxes and Federal Estate Taxes
State and federal estate taxes might also come due. The good news here is that the 2019 federal estate tax exemption is $11.4 million. An estate won't owe any estate tax if its value is less than this.
But 12 states and the District of Columbia also collect an estate tax at the state level as of 2019. These states are Connecticut, Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New York, Oregon, Rhode Island, Vermont, and Washington.
If you inherit from a decedent who did not live or own bequeathed property in any of these states, the estate won't owe any state estate taxes, just as is the case with inheritance taxes in states that collect them.
Otherwise, the value of the estate must exceed the state's estate tax exemption before any state estate taxes will be owed. Unfortunately, these exemptions are typically much less than the federal exemption. For example, it's only $1 million in Oregon and in Massachusetts as of 2019.
If the estate owes state estate taxes, these taxes must be paid before you can receive your inheritance. The amount that you receive will most likely already have been reduced by the taxes that were due.
The Bottom Line
There are many misconceptions about taxes and inheritances. Consult with an estate planning attorney or an accountant long before your tax return is due if you're not sure if you'll have to pay taxes on inherited property.
The information contained in this article is not tax or legal advice and is not a substitute for such advice. State and federal laws change frequently, and the information in this article may not reflect your own state’s laws or the most recent changes to the law. For current tax or legal advice, please consult with an accountant or an attorney.