While winning the lottery is often seen as the ultimate windfall, the odds of claiming the jackpot in a Powerball drawing are overwhelmingly stacked against us at 1 in 292 million.
Another type of financial boon that is much more common and realistic is receiving an inheritance. In fact, a recent study by benchmarking firm Hearts and Wallets found that nearly 50 million U.S. households expected to leave an inheritance in 2022, and for most recipients, it was their first time as a beneficiary.
If you’ve come into a large sum of money, either through a gift, inheritance or the sale of a valuable asset, you may find yourself meeting with a tax adviser, and they will use terms that are not typical in everyday conversation.
Understanding some income tax concepts can help heirs save a significant amount on their tax bill (which could be 50% or more in federal and state taxes) and help avoid potential issues with the tax man. To help navigate this unfamiliar territory, here is a guide to the income tax jargon commonly used when discussing windfalls.
What will I have to pay taxes on?
Generally, the good news is that if your windfall is from a gift or inheritance, the assets you receive are not considered income and are not subject to federal income tax unless and until they are sold.
Likewise, income earned by the decedent (the person who died) before their death will be taxable to their estate, not to the beneficiaries. However, income earned after the decedent’s date of death will be taxed either to the estate, the trust (if they had one) or the beneficiary, depending on who receives the income by the end of the tax year.
The estate of the decedent is generally responsible for paying taxes on any net income (after expenses like professional fees are deducted) unless the income is distributed to the beneficiaries (the persons benefiting, like you, from the trust or estate). So, if you receive a distribution, it is a good idea to ask a tax professional to estimate how much must be put aside for taxes.
When income is distributed to the beneficiaries, it’s reported by the trustee or executor on a Schedule K-1 as part of the trust or estate’s income tax return- known as Form 1041. Interest, dividends, capital gains from the sales of assets, rental income and other types of income are all reported on a K-1 schedule which is given to the beneficiary (you), and that information should be included on your personal tax return.
What are the taxes if assets are sold?
Sometimes clients ask, “If we sell the property for $1 million, will we have to pay taxes on $1 million?” Fortunately, no.
You will need to understand the concept of basis and deduct it from the sale price. Basis, according to the IRS, is the total amount of your capital investment in a property, and it includes the purchase price plus improvements made while you owned the property, less any depreciation claimed while you owned it — if the property was rented or used for business.
When someone gifts you an asset, use their basis to calculate the gain since they, not you, purchased the property. However, and this is important, a gift of property made during the donor’s life has different tax consequences than property inherited at the death of that same donor.
What is “stepped-up” basis?
When you inherit property after someone’s death, the basis of that property is stepped-up to its fair market value as of the date of the decedent’s death. It is as if you purchased the property from them when they passed away, and you receive a brand-new basis, and your taxes on the sale of the asset may be much less.
If you later sell the inherited property, you only have to pay tax on any appreciation in value that occurs after the decedent’s death rather than when the decedent initially acquired the property.
Therefore, if real property is sold immediately after the decedent’s death, it might not be taxable. If you held the property for a few years, and the value went up by $50,000, you would only pay tax on the $50K, not the increase in value from whenever the decedent purchased it.
To report the value at the date of death and your stepped-up basis, the executor or trustee will have professional appraisals prepared for most assets. If real property is sold within six months of the date of death, an appraisal is not required and you can use the sale price as the value. There might even be a loss on the sale if fix-up and sale expenses were incurred.
The taxes you pay on the sale of an asset, if held for more than one year, are called capital gains tax. The top federal capital gains tax rate of 20% is less than the maximum ordinary income tax rate of 37%, so tax planning is pertinent to minimizing taxes due on the sale of an asset.
When the administration of an estate (or trust) ends, it issues a final Form 1041; if the expenses on that final return exceed the estate’s income, those excess deductions can be claimed on your individual return (Form 1040). The good news is that due to a recent change in the tax code, you can deduct the excess deductions even if you cannot itemize deductions on your return. So, don’t forget to give your tax professional a copy of the final K-1.
Congratulations on thoroughly reading this article and expanding your knowledge of estate income tax terms! While this is a basic introduction, it’s important to remember that each situation is unique, and the tax code has many subtle complexities.
If you’ve recently received a significant gift or inheritance, consult a tax professional who can help guide you through the process.
Michelle C. Herting is a certified public accountant, accredited business valuator and accredited estate planner. She specializes in succession planning, business valuations, and settling trusts.