Do You Declare an Inheritance on Your Income Tax Return?

You may have to share your inheritance with the state tax collector.
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If you receive an inheritance from a relative or a friend, it may come with an unexpected tax bill. While there is no federal inheritance tax, some states charge you an inheritance tax on the fair market value of the assets you receive. You won’t know how much you potentially owe until the decedent’s estate is settled. After the decedent’s bills are paid, the remaining assets are distributed to the beneficiaries. Whether you declare your inheritance depends on if the decedent’s state has an inheritance tax and your relationship with the decedent.

Inheritance Tax States

You may owe tax on your inheritance if the decedent resided in one of seven states that have an inheritance tax. At the time of publication, the seven states are Iowa, Kentucky, Maryland, Nebraska, New Jersey, Pennsylvania and Tennessee. You don’t have to live in one of those seven states to potentially owe inheritance tax. For example, say your grandfather lived in Kentucky and you live in Arizona. If your grandfather died as a Kentucky resident, you can owe Kentucky inheritance tax even though you are an Arizona resident.

Family Relationship Test

The amount of inheritance tax you owe may depend on your family relationship to the decedent. You’ll pay more tax if your inheritance comes from a distant cousin rather than from a grandparent, for example. In many cases, you can inherit high-value assets from a family member’s estate without paying an inheritance tax. For example, Kentucky does not impose an inheritance tax on the assets you receive from your spouse, parent, child, grandparent or sibling. However, the assets you receive from any other decedent are taxed at the Kentucky statutory rate.

Who Must File

The person handling the decedent’s estate is responsible for filing the inheritance tax return. The tax preparer reports the decedent’s assets at their fair market value on the day the decedent died. The estate pays any state inheritance tax imposed on the assets. This lets you receive your inheritance tax-free. However, the estate does not include assets that passed outside of probate. For example, if the decedent left a bank account naming you as the pay-on-death beneficiary, that account is not part of the decedent’s estate. You are responsible for filing the inheritance tax return and paying the tax.

Federal Tax Liability

Although there is no federal inheritance tax, you may have a tax liability if you sell an inherited asset at a later date. Your asset’s basis is its fair market value on the decedent’s date of death. If the asset increases in value, you may have to pay tax on the gain. For example, say you inherit 100 shares of stock worth $10,000 on your aunt’s date of death. When you decide to sell the stock, you discover that it’s now worth $20,000. You report the $10,000 capital gain on your income tax return and pay tax on the gain.

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