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. 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 their inheritance.
Key Takeaways
- If you receive an inheritance, you typically won't need to claim it on your federal income taxes.
- You could be subject to inheritance taxes if the person who left you money lived or owned the property in one of the six states that collect inheritance tax.
- You might owe capital gains taxes if you sell property or assets you inherited.
- Depending on how much the estate is worth and where the person lived, state and federal estate taxes may be taken out of your inheritance before it passes to you.
Taxes at the Federal Level
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: 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 bequest 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.
Note
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 original price of an asset and the amount you sell it for. If you sell it for less than its value, there 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 rates that individuals are subject to on their incomes, and inheritances qualify for the long-term rate. They also receive a "step-up in 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 might 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 that 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 rather than $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 federal estate tax exemption is quite high: $12.06 million for 2022 and $12.92 million for 2023. An estate won't owe any estate tax if its value is less than this.
Twelve states and the District of Columbia also collect an estate tax at the state level: Connecticut, Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New York, Oregon, Rhode Island, Vermont, and Washington.
Note
If you inherit from a decedent who did not live in 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.
If the estate owes state estate taxes, they 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 whether you'll have to pay taxes on inherited property.
Frequently Asked Questions (FAQs)
How do you report your inheritance on your taxes?
Since an inheritance isn't considered taxable income, you do not need to report it on your tax return. However, any income you receive from an estate or that's generated from the property you inherit will be treated as taxable income or capital gains. You'll need to report this on the relevant forms on your tax return.
When do you pay taxes on your inheritance?
You'll pay taxes on your inheritance when you receive income from the estate or directly from money generated by the assets. The estate may also have to pay federal and state taxes before the inheritance is passed to you.
