Inheriting assets from a loved one can be a significant financial event. Still, it often comes with a complex web of tax implications that can affect the value of the inheritance.
Inheritance involves transferring assets from the decedent’s estate to their beneficiaries or heirs after death. This process can be subject to various taxes, depending on several factors, including the estate’s value, the beneficiary’s relationship to the deceased person, and the laws of the state where the decedent lived or where the property is located.
Understanding inheritance tax is important for estate planning and beneficiaries trying to understand their tax liabilities. We want to identify the taxes associated with an inheritance, highlighting key concepts such as gift tax, exemption limits, tax rates, and the importance of state law in determining the overall tax burden on inherited assets.
By exploring how these taxes work and which assets are likely to be taxed, beneficiaries can better prepare for the financial implications of receiving an inheritance.
Please note, you should always contant a tax professional and attorney before making any decisions. This content is for educational purposes only and not investment, legal or tax advice.
What Is an Inheritance?
Inheritance refers to the process and the assets individuals receive from someone who has passed away, often a family member or close relative. This transfer of wealth can encompass a wide range of assets, including money in bank accounts, real estate properties, investments such as stocks or bonds, personal possessions, and even interests in a business.
The foundation of inheritance is the decedent’s estate, which represents their assets and liabilities at the time of death. The distribution of these assets to heirs or beneficiaries is typically governed by the deceased person’s will, a legal document outlining their wishes regarding the disposition of their estate. In cases where a will is absent, state laws, known as intestacy laws, determine how the estate is divided among surviving relatives.
Transferring assets from the decedent’s estate to the beneficiaries may go through probate, a legal procedure where a court oversees the distribution of the estate. This includes validating the will, settling outstanding debts, and distributing the remaining assets to the rightful heirs.
Some assets, like those held in an irrevocable trust or life insurance proceeds with a designated beneficiary, can bypass the probate process and go directly to the named beneficiaries.
What Taxes Are Associated With an Inheritance?
The taxes associated with an inheritance can vary widely, depending on the type of assets, their value, and the jurisdiction laws in which the deceased person resided or where the property is located.
Understanding these taxes is essential for beneficiaries to assess their financial responsibilities accurately and for estate planning.
Is There a Federal Inheritance Tax?
There is a common misconception about an inheritance tax at the federal level, but the U.S. does not impose a federal tax on beneficiaries. Instead, the federal government levies an estate tax, which is charged against the decedent’s estate based on its total value before the distribution of any assets to heirs.
This tax only applies if the estate exceeds a certain exemption threshold of $12.06 million for individuals and $24.12 million for married couples in 2022. It’s important to note that this estate tax is deducted from the estate itself, not from the individual inheritances received by the beneficiaries.
However, income generated from inherited assets, such as dividends or interest, may be subject to federal income tax.
Which States Have an Inheritance Tax?
While the federal government does not impose an inheritance tax, several states do. Currently, six states have an inheritance tax: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania.
Inheritance tax rates and exemptions in these states can vary significantly based on the relationship between the deceased and the beneficiary. Generally, closer relatives such as spouses and children often enjoy lower tax rates or exemptions, while more distant relatives and non-relatives may face higher rates.
For example, in Pennsylvania, spouses are exempt from inheritance tax. At the same time, children and parents pay a lower rate, and more distant relatives or non-relatives are taxed at a higher rate. Each state has its own set of rules and exemptions. In some cases, the value of the inheritance or the specific asset type can affect the tax rate or exemption eligibility.
Beneficiaries must understand the specific inheritance tax laws of the state where the deceased person lived or where the inherited property is located. Consulting with a tax professional or estate planning expert can provide valuable guidance in determining state laws and any potential tax liabilities associated with an inheritance.
Who Has To Pay Inheritance Taxes?
Inheritance taxes, where applicable, are imposed on the assets passed from the deceased’s estate to their heirs or beneficiaries. However, the obligation to pay these taxes and the rate at which they are levied can vary significantly depending on several factors, including the state’s laws where the estate is located, the relationship between the deceased and the beneficiary, and the value of the assets inherited.
In the states that impose a state estate tax — Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania — the tax is typically paid by the beneficiary, not the estate itself. This is an important distinction from the federal estate tax levied on the estate before distribution to the beneficiaries.
The beneficiary’s relationship to the decedent often determines the inheritance tax rate and any applicable exemptions. Generally, spouses are exempt from inheritance tax, reflecting the policy of minimizing financial burdens on surviving spouses. Similarly, children, grandchildren, and sometimes parents of the deceased may also enjoy exemptions or be subject to lower tax rates, acknowledging the close familial relationship.
For more distant relatives or non-relatives, the tax rates tend to be higher, and fewer exemptions are available. This tiered system aims to reflect the varying degrees of closeness and support typically found in different relationships. Each state has its own set of rules regarding these relationships and the corresponding tax rates, making it essential for beneficiaries to familiarize themselves with the state’s specific laws where the estate is being probated.
Are All Assets Subject to Inheritance Tax?
It’s also important to note that not all assets may be subject to inheritance tax. Certain property types, such as life insurance proceeds paid directly to a named beneficiary, may be exempt from inheritance tax in some states.
Additionally, the value of the assets inherited plays an important role, as many states offer exemptions or deductions based on the value of the inheritance, with smaller estates often being exempt from tax or eligible for reduced rates.
Given the intricacy of inheritance tax laws and the variations across different states, beneficiaries should consult with a tax professional or an estate planning attorney. These experts can provide guidance on the specific tax obligations in their situation.
They can also help you navigate the filing of any required tax forms and advise on strategies to minimize the tax burden, such as through the use of irrevocable trusts or by making strategic bequests to charities or nonprofits.
How Are Inheritance Taxes Calculated?
Inheritance taxes are calculated based on the value of the assets an individual inherits from a deceased person’s estate. The specific method of calculation and the rates applied can vary significantly depending on the state’s laws where the inheritance tax is applicable.
Generally, the process involves determining the fair market value of the inherited assets as of the date of the decedent’s death and then applying the relevant tax rate, which may be influenced by the beneficiary’s relationship to the deceased and the total value of the assets inherited.
For instance, states with inheritance taxes often have different tax brackets or rates based on the closeness of the familial relationship, with spouses and direct descendants typically facing lower rates or exemptions. The tax rate might increase for more distant relatives or non-relatives. Additionally, some states provide exemptions or deductions for smaller estates or specific types of assets, which can reduce the taxable value of the inheritance.
How Are Inheritance Taxes and Estate Taxes Different?
It’s important to distinguish between inheritance and estate taxes, as they are two separate forms of taxation. Inheritance tax is paid by the beneficiary on the assets received from the estate, with the rate and exemption levels determined by the beneficiary’s relationship to the decedent and the laws of the state imposing the tax.
In contrast, the estate tax is levied on the entire value of the decedent’s estate before the assets are distributed to the beneficiaries. The federal government and some states impose estate taxes, but the obligation to pay these taxes falls on the estate itself, not the individual heirs. The estate tax rate is applied after accounting for deductions, exemptions (such as the federal estate tax exemption), and the calculation of the estate’s total taxable value.
Is It Possible To Avoid Inheritance Tax?
While avoiding inheritance tax entirely may not be possible in states where it is imposed, there are strategies to minimize its impact. Proper estate planning can help in reducing the taxable value of an inheritance.
Some standard methods include:
- Gifting Assets During Lifetime: Individuals can gift assets to their heirs while still alive, as gifts up to a specific annual and lifetime exemption limit are not subject to gift tax.
- Establishing Trusts: Placing assets in certain types of trusts, such as an irrevocable trust, can remove them from the taxable estate, potentially reducing the inheritance tax liability.
- Life Insurance: Proceeds from life insurance policies paid directly to a named beneficiary are not considered part of the estate for estate tax purposes and are typically exempt from inheritance tax.
- Taking Advantage of State Exemptions: Understanding the exemptions available in your state, such as those for spouses and direct descendants, can help plan the distribution of assets to minimize tax liabilities.
How Can You Make the Most of Your Inheritance?
When inheriting assets, whether real estate, IRAs, savings accounts, or various assets, understanding the associated tax responsibilities — such as inheritance tax, federal estate tax, and income tax on earnings from inherited assets — is essential.
Investing your inheritance thoughtfully, particularly in multifamily and commercial real estate, can be a strategic way to grow your inheritance while considering these tax implications.
Investing in Real Estate
Investing in multifamily properties, like complexes, offers a way to generate continuous income through rent. This investment can be particularly advantageous when considering the potential tax benefits, such as depreciation, maintenance, and mortgage interest deductions, which can offset the income generated, potentially reducing the overall tax burden.
Moreover, for estates subject to state inheritance tax — like in Pennsylvania, Kentucky, or New Jersey — strategically investing in real estate can diversify and potentially enhance the value of your inheritance beyond the immediate tax implications.
Commercial properties, including office spaces and retail locations, represent another avenue for growing your inheritance. These investments can provide higher rental yields than multifamily real estate and may offer longer lease terms, contributing to a stable and predictable cash flow.
However, potential investors should be mindful of the specific tax laws and rates applicable in their state, as places like Maryland, Nebraska, and Iowa have distinct rules regarding the taxation of inherited properties and the income they generate.
The Bottom Line
Inheriting assets can significantly impact your financial future, offering a unique opportunity to invest and grow your wealth. Real estate, especially multifamily and commercial properties, is an intelligent investment choice due to its potential for steady income and capital appreciation.
Knowing the tax implications of an inheritance, from understanding state laws to managing federal taxes, is essential for making the most of your inheritance.
Headway Capital offers tailored investment opportunities in real estate for those looking to invest their inheritance wisely. With expert guidance and a focus on strategic growth, we can help you transform your inheritance into a lasting legacy.
Let us do the work for you. Contact us today to learn more.
Sources:
Inheritance: Definition, How It Works, and Taxes | Investopedia
States With Estate Tax or Inheritance Tax, 2021 | Tax Foundation
Inheritance Tax: Who Pays, How to Calculate, and How to Avoid It | Business Insider
Strategies for How to Avoid Inheritance Taxes – SmartAsset | SmartAsset
