Inheritance tax basics: What it is and how it works

Inheritance tax, also known as death tax or federal estate tax is an important tax talk you’ll run into if certain personal property passes down to you. Inheritance tax applies to property over a certain amount, and it covers a lot of ground. To be honest, several concepts related to inheritance sound alike, so we’ll talk through the nuances.

We’ll also answer the questions, “Is inheritance taxable?” and “Do you pay taxes on inheritance?” to help you better understand the tax treatment of inherited property.

Read on for more inheritance tax information.

What is inheritance tax?

Inheritance tax is a tax on everything the deceased owned or had an interest in at the time of their death. Basically, it is a tax levied on the transfer of assets or property from one person to another after the original owner’s death. The estate will pay the federal inheritance tax if the estate is worth more than $12,920,000 and the original owner passed away in 2023. This tax is different than the income tax return an estate might file to pay income tax during the tax year.

If you are a beneficiary of property or income from the estate, you could be impacted on your federal income tax return. You must report any income you receive passed through from the estate to you and reported on a Schedule K-1 (1041) on your income tax return. In addition, any property you receive from the estate will typically be considered valued at its fair market value at the date of the original owner’s death. This will be true regardless of whether the estate in question was big enough to pay the federal estate tax. This will become important if you decide to sell that property later. These rules apply to all property, including: 

• Bonuses
• Crops and livestock
• Installment obligations
• Interest and dividends
• Investments
• Partnership income
• Qualified retirement income
• Real estate
• Royalties
• Stocks

Do you pay taxes on inheritance?

While receiving money or property is generally thought of as a financial windfall, many people will also worry about what it means for their taxes. “Does inheritance count as income?” is a common question for beneficiaries. Whether you personally will have to pay inheritance taxes will depend on several circumstances. Read on to understand the various scenarios.

Are there income tax consequences related to a bequest?

In some situations, you may not have an immediate tax liability. However, if the property you receive as a bequest (i.e., inherited property) produces income such as interest, dividends, or rents, your inherited property is taxable on the income tax return to whomever inherited the property. This includes income from property that is given to a trust or held in the estate and paid, credited, or distributed to a beneficiary.

How to report inheritance to the IRS

If you’re wondering, “How much is inheritance tax?” then the answer is not clear cut. As stated above, the taxation of your inheritance depends on how the property was bequeathed to you by the deceased family member, what type of property was bequeathed to you, and what you decide to do with the property you inherited. Follow along as we report some common scenarios of inheriting property – and how to report inheritance to the IRS.

1. Reporting inheritance to the Internal Revenue Service as income: “In Respect of a Decedent”

In respect of a decedent is a phrase used to describe certain financial and legal matters related to a deceased individual, or decedent. It refers to income earned by the decedent before their death, but not paid until after the decedent passed away. The income to the beneficiary will be reported on the beneficiary’s tax return the same way it would have been reported on the deceased’s tax return if it had been paid before death. Examples of income in respect of a decedent can include interest, dividends, gain on the sale of property (if agreement was signed before date of death and sale completed after death), gross profit from installment sales, or distributions from annuities, IRAs, or employer retirement plans.

2. Is the sale of inherited property taxable? Another case to explain

Upon selling an inherited asset, if the inherited property produces a gain, you must report it as income on your federal income tax return as a beneficiary.

 An inherited property’s basis from a decedent is one of the following:

• The property’s fair market value on the date of the decedent’s death, or
• The property’s fair market value on the alternate valuation date if the estate executor chooses to use alternate valuation.

Essentially, you pay federal income taxes on the difference in the basis (the property’s value on the date the individual died) and a higher sales price you get when you sell the property.

Let us explain further through a couple of examples:

Scenario 1: Inheriting a house: A tale of inheritance and home ownership

You inherit a home from your aunt. It was originally purchased for $125,000 in 1970. After she passed in 2000, the home was valued at $575,000 and you lived in the home for 23 years. You then sold the home for $1 million. You would incur a $425,000 gain ($1 million less $575,000). Since you lived in the home and owned it, you might qualify for the sale of home exclusion of $250,000 (or $500,000 if you are married filing a joint return). If you have any gain left over after the sale of home exclusion, you will be taxed at the long-term capital gain tax rates.

Scenario 2: Inheriting a house: Calculating capital gains

If, instead, your aunt lived until 2023, then your aunt passed when the house was worth $1 million, and you inherit it at that point. You decided to sell the house 3 months after you received it for $1,005,000. You would have a $5,000 gain ($1,005,000 less $1,000,000). Since you inherited property, you are treated as having a long-term holding period even though you only owned the home for 3 months. Since you did not live in the house, you will not be able to take the sale of home exclusion. In this case, you would pay taxes on the $5,000 long-term gain at the capital gain rates (depending on your AGI). While this sounds like bad luck, there’s a silver lining: You could also use these capital gains to offset any capital losses you incurred during the year.]

In most cases, you’ll use your inherited basis and sale information to complete Tax Form 8949, so you can report your gains and losses on Schedule D.

2. Property passed through a trust

A trust is when a grantor gives a trustee the right to hold property or assets for the benefit of a beneficiary. It’s often used as a mechanism to transfer income from property to one person for a fixed term or for that person’s life and then transfer the actual property to another person after a specific event.

As a trust beneficiary, when you get distributions from the trust’s principal, you don’t have to pay taxes on this disbursement. However, if you get distributions (or you are required to get distributions from income), you will pay income tax on the income to the trust. You will receive a Schedule K-1 (1041) that will help you report the income on your income tax return. 

If there is no requirement that the trust distributes income and the trust does not distribute income, the gains in the trust are taxable to the trust at the following tax rates for 2023:

An example:

Your grandpa passed away. His will leaves a stock portfolio valued at $1 million in a trust with income paid to his children (your parents and aunts/uncles) for 15 years, and then the stocks are to be distributed to his grandchildren once those 15 years have passed. During the 15-year period, his children would have received a Schedule K-1 (1041) each year indicating how much income they would have to pay in their personal income tax returns.

In 2023, the trust dissolved, and the principal (the stock) was distributed to his 5 grandchildren. As a grandchild and beneficiary, you will have received a distribution of $680,000 in stock, which includes a transferred basis of $200,000 (the fair market value at your grandpa’s death). You will have a tacked holding period, meaning that if you sold all the stock within three months of getting it, you would have $480,000 ($680,000 less $200,000) of long-term capital gains.

You would pay tax on your $480,000 of gain at the 0%, 15%, or 20% capital gain rates (depending on your AGI). You could also use capital gains to offset any capital losses you incurred during the year. The fiduciary should provide you with information in the year of your distribution, indicating your basis and holding period.

Which states require you to report and pay inheritance tax?

Inheritance tax may also exist at the state level, so it’s important to be mindful of state tax laws. You can also talk to your tax professional about any state inheritance tax questions or concerns.

11 states have an estate tax (where the estate fills out a state estate tax return if required):

• Connecticut
• Hawaii
• Illinois
• Maine
• Maryland
• Massachusetts
• Minnesota
• New York
• Oregon
• Rhode Island
• Vermont
• Washington
• Washington, D.C.

Five states have inheritance tax (Tax on what you receive as a beneficiary of an estate):

• Iowa
• Kentucky
• Maryland
• Nebraska
• New Jersey
• Pennsylvania

Get more help with inheritance income

If you have recently come into inheritance money and are looking for a way to maximize your tax savings, learn about ways to file with H&R Block. By filing with a tax pro, you can rest assured that we’ll get you the biggest refund possible, taking your unique inheritance tax situation into consideration.