When someone you love passes away, it can be a heartbreaking and confusing time. To make matters more difficult, you must think about how to pay taxes on your family inheritance. If you inherit any property, it's important to learn how to legally reduce or remove the taxes you pay on the property or its sale.
Avoid Three Types of Taxes
If a loved one leaves you a house, you should look out for three types of taxes: estate, inheritance and capital gains. While estate and inheritance taxes may seem similar, they have important differences to you and your finances. An estate tax comes out of the deceased person's accounts before any inheritance goes out. On the other hand, the benefactor is responsible for any inheritance taxes.
Capital gains taxes are not exclusive to inherited properties, but they can sometimes apply. If you make improvements to the house or wait to sell until property prices rise, you could owe capital gains taxes. This fee only applies to the difference between the value on the day of death and the sale amount on the home. Just by being aware of these types of taxes, you take the first step toward reducing your tax burden. For each tax, you must consider the federal and state laws regarding it.
If you inherit any property of any value from your legal spouse, the IRS does not put estate or inheritance taxes on it. This rule includes property that only had the deceased spouse's name on the deed, like a painting or a car. Furthermore, surviving spouses can use the remainder of the deceased spouse's individual deduction to lower their taxes.
If the property passes to someone other than the person's spouse, the federal government may require estate taxes. However, only estates worth millions pay federal taxes. If you add up all the property and accounts in the estate and the sum is under the federal limit, the estate will not owe anything to the IRS. Washington, D.C. and 12 states have estate taxes as well. Many of these jurisdictions are raising the limits so that only massive estates pay these taxes. The lowest threshold of these states is 1 million. So, it's possible to owe the IRS nothing but still owe your state.
The IRS does not have an inheritance tax. However, six states do impose taxes on the value of the property that you inherit. If you live in Iowa, Kentucky, Maryland, Nebraska, New Jersey or Pennsylvania, you could owe the state money on your inheritance. Each of these states has limits on when an inheritance becomes taxable. So, if the total you receive is under that amount, you do not have to pay. For married couples, this amount is often double the single person's limit. You can reduce your potential inheritance tax by asking your loved ones to write both you and your spouse into their wills before they pass.
You can also avoid inheritance taxes by declining the property altogether. Notify the executor that you do not want the property, and it will pass to the next heir in line. If you do this, you never owned the property, so you cannot owe on it.
While heirs have little say over how much they owe in estate or inheritance taxes, capital gains taxes are largely avoidable. You only pay these taxes on the property if you sell it for more than what its fair market value was on the day of the person's death. The executor of the will should provide a statement of the fair market value. For example, if you inherit a house worth $200,000 on the day of the person's death and sell it for $250,000, you pay taxes on the $50,000 profit. However, if you sell the same house for $200,000 or less, you will not pay capital gains taxes. The same principle stands for other valuable goods.
Houses offer another unique way of legally avoiding taxes. If you live in the inherited home for at least two years before you sell it, you do not have to pay capital gains on $250,000 of the gains you make when you sell it (or $500,000 for married couples).
When You Have to Pay
Inheritance taxes prove that both death and taxes are unavoidable sometimes. Even with smart planning, you can still end up owing taxes on your inheritance. For example, if the person who passed had such a large estate that it exceeded that year's limits, and he did not leave the property to a spouse, the estate tax is all but inevitable. Of course, the executor should pay the estate tax before any heirs get property or cash. Therefore, this tax may affect how much you inherit, but it will not affect your taxes directly.
Inheritance and capital gains taxes can be more tricky. If you live in a state that charges inheritance taxes, be sure to know your state's limits. If you do not decline any of the property and your share goes over the state limit, you will be responsible for taxes on the inheritance.
Before you worry about inheritance tax on a house, be sure to calculate everything correctly. The limit on inheritance applies to what you gain from the estate, not what the estate is worth as a whole. For example, imagine an estate is worth $5 million and the inheritance limit in the state is $2 million. If you are one of five equal heirs, you may get $1 million in property and other assets. You would not owe in this situation. However, if you are one of only two equal heirs, you inherit $2.5 million. Depending on your state's laws, you could owe taxes on the half million above the limit or on the whole inheritance.
Capital gains tax is easier to avoid, but there are still some circumstances in which you may want to go ahead and pay it. For example, consider a house that was worth $300,000 on the day of death. Perhaps it takes six months for the executor to process everything in the estate. In that time, the value of the house goes up to $350,000 before you can legally sell it. You could sell it for under market value at $300,000 and avoid paying capital gains taxes. However, if you sell it for $350,000, you could owe on the $50,000 gains. Depending on your income tax bracket, your capital gains rate could be zero. Even if you are in a higher tax bracket, you could pay up to 20 percent on the $50,000.
Remember that you will not pay this rate on the original $300,000, only on anything above that. If you sell for $300,000, you get none of the additional $50,000. However, if you sell it for what it's worth, you get to keep at least 80 percent of the gains. In this case, it's well worth the extra effort.
2018 Inheritance Tax on Property
If you inherited property in 2018, you will put it on the taxes you file in 2019. If your inheritance would go on this year's taxes, estates pay no federal taxes unless the estate reaches $11.2 million for individuals or $22.4 million for couples. New Jersey also eliminated its estate tax starting in 2018.
2017 Inheritance Tax on Property
If you filed for an extension and you're still working on your 2017 taxes, you will follow the rules and limits for that year. The estate tax exemption for 2017 is $5.6 million for individuals and double for couples. Federal income tax brackets also changed between 2017 and 2018, which can affect capital gains taxes.
- Take time once a year to re-evaluate all of your trusts, co-ownerships and bank documents to be sure you still wish to have them set up the way they are set up. If you pass without changing them, your loved ones could end up not getting the property you wanted to leave them.
- NerdWallet: Estate Tax: How It Works and Which States Have One
- IRS: Estate Tax
- KDP Certified Public Accountants: 2017 vs. 2018 Federal Income Tax Brackets
- SmartAsset: Capital Gains Tax Calculator
- AllLaw: Must You Pay Income Tax on Inherited Money?
- IRS: Gifts & Inheritances
- Intuit TurboTax: What Are Inheritance Taxes?
- NerdWallet: Will Your Taxes Go Up or Down Under the New Tax Rules?
- NerdWallet: Find Out If You’ll Owe Taxes on an Inheritance