The Internal Revenue Service taxes a decedent's right to pass his property to his beneficiaries when he dies, subject to certain thresholds based on the value of his estate. His estate pays these taxes, however, not his beneficiaries. Federal law doesn't provide for inheritance taxes – payable by beneficiaries – but tax law is full of catches. Depending on what's included in the probate inheritance and what you do with it, the IRS might be entitled to a portion.
Whether or not a probate inheritance is taxable will primarily depend upon what specifically is found within it.
Defining Probate Assets
Probate assets are those that require court intervention to legally pass from the name of the decedent to a new owner – his beneficiary. They typically include anything held solely in the decedent's name because jointly held assets often transfer automatically to the other owner by contract.
Likewise, many retirement benefits and life insurance policies pass directly to beneficiaries, so they're not subject to probate either. An exception exists when the named beneficiary of a policy or retirement plan is the decedent's estate. When any asset is payable to the estate, it becomes a probate asset, and possibly subjected to probate tax.
Interest and Dividends
Most of what you inherit through a probate account is not taxable. If the decedent leaves you cash, it's not income to you and you don't have to report it. Nor are you taxed on real estate inheritances, stocks or tangible personal property. If your inherited asset begins producing interest or dividends, however, this is a different matter.
The interest, dividends or gains are income to you after the asset is in your ownership and you must report them on your tax return. If you inherit a home and rent it out, the rent you receive is taxable.
Income in Respect of Decedent
Income in respect of a decedent is that which he earned before he died, even if you or his estate don't receive the money until after his death. For example, if you inherit an investment account that pays interest quarterly, and if the decedent dies before the interest for the current quarter is paid out, the portion that accrued before the decedent's date of death is income in respect of a decedent.
In many cases, the executor of his estate will include this income on the estate's income tax return. You don't have to report it or pay taxes on it. However, if the estate's executor does not do this, you're responsible for claiming all of it on your own return, both the interest earned before the date of death and after.
Evaluating Capital Gains
Another tax issue arises if you sell an inherited asset. If the sale is in excess of the asset's tax basis, this is capital gains and you'll owe a tax. Fortunately, the tax basis is not what the decedent paid for it, but its value as of the date of his death. Executors can opt for a different date, but it's usually only six months later.
In either case, your tax basis is whatever the executor values the item at for estate tax purposes. If you inherit a home that's worth $300,000 on that date, and if you sell it later for $250,000 in a depressed market, you've got a capital loss. If you sell it for $320,000, you'll owe capital gains tax on $20,000.
Assessing Current State Laws
Although federal tax law is fairly generous with inheritances, not all states follow suit. Six of them – Kentucky, Nebraska, Pennsylvania, New Jersey, Maryland, and Iowa – tax beneficiaries on inherited assets. The tax is typically a percentage of the inheritance's value, but the exact amount varies by state.
Several states exempt surviving spouses from such taxation, but if you're not related to the decedent or if you're distantly related, you'll most likely owe the state government.