The Effects of Inheriting a Promissory Note on Your Income Taxes

The income on inherited notes is taxable.

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A promissory note is an IOU of sorts, by which one person promises to pay another a sum of money. Inheriting a promissory note puts you in the position of receiving a string of note payments for months or years. Those payments will be taxable for you just as they were to the original owner from whom you inherited the note. The value of the note will be included in the estate, as well, and will be subject to estate tax.

Estate Tax

Anything that you inherit carries no estate tax for you. The Internal Revenue Service requires estates to pay the tax before they pass on assets to heirs. For the 2013 tax year, an individual has a total gift and estate exclusion of $5.25 million; that means the first $5.25 million of taxable gifts or estate value is tax free. Anything over that threshold is subject to a top federal rate of 40 percent, as well as state tax, if your state taxes inheritances. According to the Center on Budget and Policy Priorities, only 0.14 percent of estates ever pay estate tax, so it's likely that the note will pass to you tax free.

Income Tax

The interest payments that you receive under the promissory note are taxable as income. Since many promissory notes have a payment schedule that mixes principal and interest, you'll have to find a way to determine how much of the payments are taxable interest and how much aren't. This information is important so you can correctly report the interest income on the Schedule B form that you attach to your Form 1040 tax return. If your promissory note doesn't come with an amortization schedule, an accountant or banker can help you prepare one. Or you can prepare one yourself with an amortization calculator or spreadsheet.

Capital Gains Tax

When you inherit the promissory note, you will generally inherit it at its fair market value as of the date the original owner died. If the fair market value of the note is less than the total amount owed on the note, you could end up with capital gains liability when the note matures and you collect a total amount that is more than the value that was originally assigned to the note. For example, this would come into play if you had a note on which the borrower still owed $15,000, but the fair market value of the note, as estimated by a professional note appraiser, was $11,000 because the borrower was a bad credit risk.

Inheriting a Debt

If, instead of inheriting a note, your relative dies owing money on a promissory note, the implications are different. You have no responsibility for another person's debt. This holds true as long as you didn't co-sign the note and you aren't married to the decedent. However, the note holder will have a claim on the estate and can collect from it, potentially reducing your proceeds.