Losing a loved one is never easy, but if the person left you an inheritance, you can take some solace in knowing you live in the right place. Arizona has no inheritance or estate tax. Arizona does have a personal income tax, however, so you may wonder if that will cut into your inheritance. Again, you're pretty much free and clear, with some exceptions.
State Follows Federal
While Arizonans tend to be pretty independent, they follow a lot of the federal tax code when it comes to the state income tax. So you start with your federal adjusted gross income, then add some things Arizona taxes that the federal government does not and vice versa. Arizona treats inheritance the same way the federal government does for income tax purposes.
A Step Up
Just as on your federal return, whether the asset is worth $100, $1,000 or $1 million, you will not declare inherited assets such as stocks, bonds or real property as income on your Arizona income tax return. Further, when you sell the inherited asset, the tax basis will be the date of the deceased owner's death, rather than the date the original owner purchased the asset. In other words, it's as though you purchased the asset on the date the person died, and the only capital gains you will report are those that occurred after the date of death.
Paying the Piper
The exception is assets for which the deceased deferred paying taxes during her lifetime. This is perfectly legal and applies mostly to retirement plans, but can apply to some other assets as well. If you inherit an annuity purchased with after-tax dollars, you will have to report the untaxed investment income. Generally, all income from a traditional IRA or 401(k), excluding any after-tax contributions made by the deceased, should be reported on your Arizona income tax. You normally have options on how to take distributions, so you should consider discussing your options for minimizing both Arizona and federal taxes with a tax professional.
What's Yours Is Yours
Investment income up to the date of death from interest or dividends will normally be included on the deceased's final Arizona income tax return. However, anything earned after that date belongs to someone else. Until the estate is settled, it may be included on the estate return. Once the asset has been transferred into your name as an heir, you will be responsible for reporting that income on your Arizona return.
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