Will Inheritance Money Be Subject to Federal Income Tax?

Inheritance money isn't hit with income taxes.

Inheritance money isn't hit with income taxes.

Money you receive as an inheritance isn't considered income for tax purposes. Though you might be required to pay a state inheritance tax, depending on where the decedent died, you won't have to share any of the money with the federal government. However, if you received a retirement plan or property as part of your bequest, you might owe some taxes when you take distributions or sell.

Special Rules for Retirement Plans

If you were named as a beneficiary of an individual retirement account or employer plan, like a 401(k) or 403(b), you will end up paying taxes on the distributions from the account just like the decedent would have owed taxes if he had taken the withdrawals. However, the money isn't taxed until you take it out of the account. For example, suppose you inherit a $45,000 traditional IRA. You don't pay taxes on the entire $45,000 immediately, but if you withdraw $12,000, that $12,000 counts as taxable income.

Inherited Property Basis

When you sell property, the first thing you need to know from a tax standpoint is your basis, or what you paid for it. Obviously, you didn't pay anything for the property you inherited. However, that doesn't make your basis zero. Instead, your basis becomes the fair market value of the property on the date the decedent died no matter how much the decedent paid for it. For example, say you inherit a condo from a parent. If the condo was worth $70,000 at the time of death, your basis is $70,000 regardless of whether your parent paid $7,000 or $700,000 to buy it.

Calculating Gains or Losses

To figure your gain or loss, subtract your basis from what you received from the sale. If it's a positive number, you have a taxable gain to report. For example, say the condo you inherited sells for $73,000. Subtracting your basis of $70,000 gives you a taxable gain of $3,000 that you must report on your federal income taxes. If you sell the property shortly after inheriting it, chances are you'll have a minimal gain or loss because the value won't have changed drastically in such a short period of time. But if you hold it for years, it's more likely the price has changed substantially.

Tax Impact

Just about any property held for personal or investment use counts as a capital asset -- cars, condos, mutual fund shares, or even furniture. If it were property that you bought, you would have to own it for more than one year to have the gains taxed at the lower long-term capital gains rates. Because you inherited it, however, you pay the lower long-term capital gains rates on your profit no matter when you sell it.

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