When a person gets an inheritance in the event of a friend’s or family member’s death, they may need to pay a tax on inheritance. Depending on what a person receives as a legacy from the deceased, there may be one or more liable taxes. The number of taxes also depends on what the person does with the inheritance they receive.
What are the types of taxes related to inheritance?
There are mainly three types of taxes when it comes to inheritance in the US. These taxes are as follows:
As the name suggests, this means the tax on inheritance that the receiver of the legacy has to pay. Here the incidence of the tax on inheritance falls upon the beneficiary. At the federal level, the IRS does not consider bequest as income. Therefore, cash received by the recipient will remain tax-free.
Six states in the US impose a tax on inheritance. They are New Jersey, Maryland, Iowa, Kentucky, Pennsylvania, and Nebraska. What this means is that if the recipient lives in another state besides these six, they will not have to pay inheritance tax.
Even amongst these six states, there is an exemption when it is the spouse of the deceased person receiving the property or legacy. They do not have to pay a tax on inheritance. If it is the children or grandchildren receiving the property, only Pennsylvania and Nebraska will levy an inheritance tax.
Capital gains tax
If the recipient of the inheritance sells the property, estate, or asset, they will need to pay a tax called capital gains tax on the amount they gain. Here, one thing to keep in mind is that if the person who received the legacy sells it for less than its value, that person will not need to pay capital gains tax. Why? Because there will be a loss and no gain.
This tax is actually the tax on what a person gains from selling the inheritance and not the inheritance itself. Capital gains tax depends on the current value of the property or asset and not the purchase value at which the decedent bought it.
An example to illustrate this statement is if the decedent buys a property for $80,000 some years back, and now, the recipient sells it for $150,000. Here it might seem as though there is a capital gain of $70,000. But the capital gains tax will not be on this amount. It will be on the difference between the current value and the price at which the person sells it.
Suppose the current value is $120,000, there is a capital gain of $30,000. This $30,000 is the gain on which a person will calculate the amount of tax due.
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An estate tax is another tax on inheritance in the United States. The main difference between estate taxes and inheritance taxes is who pays the tax. When it comes to inheritance tax, it is the recipient who ultimately pays the final amount. On the other hand, for an estate tax, the amount due is on the estate. What this statement means is that the estate has to pay what it owes before the recipient gets the inheritance.
At the federal level, any estate with a value of less than $11.4 million will not need to pay any estate tax. However, 12 states collect this tax. And the bad news is, for any estate in Oregon and Massachusetts with a value above $1 million, they will have to pay this tax before taking any further action.
Tips to reduce tax on inheritance
Although the inheritance that a person receives might need to clear some taxes first, there are some ways through which the recipient can reduce this amount:
Study the valuation date
If the recipient receives property or estate as inheritance, the value of such property will be the market value at the date of death. There may be a choice to change this date to six months after the date of death. How this benefits the recipient is by reducing both the amount of estate and tax.
The value of the estate if the beneficiary sells it off during those six months, will be at the cost on the day the sale takes place. In case the estate does not fall under any estate tax, its value will be the value at the time of death.
Set up a trust
Sometimes there is no shadow of a doubt that a person will receive an inheritance from their parents or family members. In such cases, it is best to encourage them to set up a trust for this specific purpose.
The thing about putting the assets into a trust is that it will be able to avoid state probate requirements. What this does is the recipient will not need to pay any extra expenses related to officially proving the will.
Give some away
Giving some parts of the legacy away will help both the recipient and those in need. Sometimes, a person can get tax deductions based on the amount they give off to charity or any charitable organization. Gifting some amount to the beneficiaries will also help in reducing the amount of payable tax.
Consider taking out life insurance
What this does is help in paying off the tax on inheritance. It will not reduce the amount of inheritance tax in any way. One thing to keep in mind here is to make sure that the payout goes into a trust to avoid making the estate bigger than it already is.
There are three taxes on inheritance, and each of them is very different from each other despite having the same basis. Inheritance tax falls on the recipient for the legacy they receive. In contrast, the estate tax falls on the estate and not the beneficiary. The capital gain tax falls on any gain made on selling off the property.
Tax on inheritance may be difficult to avoid entirely. However, there is no need to give it all away to avoid the charges either. Putting the property and assets into a trust will help in avoiding extra expenses while selling them off at a loss will help in avoiding capital gain taxes.