Guiding Clients through Taxes on Their Inheritance

There are a variety of taxes that may be levied on those who inherit assets. Federal estate taxes and capital gains taxes may apply, and Pennsylvania is one of only five states that also levy an inheritance tax. PA accountants and CPAs should be proficient in the nuances and details of inheritance tax and other taxes in order to help their clients with their inheritances.

The federal government levies an estate tax on estates over $13,990,000, and those taxes are taken out of the estate, not payable by your client.

Capital gains taxes may apply, as usual, to any assets that your client inherits and then sells. However, they are calculated based on a stepped-up cost basis. If your client inherits property or stock valued at $100,000 that his parents bought for $50,000, which he then sells later for $125,000, he will pay capital gains only on the $25,000 difference between its value upon inheritance and its value at sale. He will not pay on the $75,000 increase from its original purchase.

Federal income tax is generally not due on inheritances, though it will be applied to any interest, dividends, etc. that may be generated. Furthermore, any assets inherited in the form of pre-tax accounts, such as traditional IRAs, 401(k) accounts, or HSA accounts, will be taxable upon withdrawal, as usual.

PA inheritance tax rules are very complicated. Keep an eye on the PSTAP website for courses on PA inheritance taxes in the spring. Below is a general summary of who pays PA inheritance taxes and how much.

• Surviving spouses who owned marital property jointly with the decedent are exempt

• Parents inheriting assets from a child aged 21 or younger are taxed at 0%

• Property or assets inherited from a nonresident of PA that are not located in PA are exempt

• Intangible assets, such as stocks, bonds, bank accounts, etc., held by a nonresident decedent are exempt

• Property or assets located outside of PA that are inherited from a PA resident are exempt

• Certain farmland and other agricultural property is exempt, provided the property is transferred to an eligible recipient (details at the PA Dept. of Revenue website)

•  Estates of military members who have died as a result of injury or illness received while on active duty are exempt

All real property and all tangible personal property of a decedent who is a PA resident, which is located in Pennsylvania at the time of the decedent’s death, is taxable. All intangible property of a resident decedent, including stocks, bonds, bank accounts, loans receivable, etc., is also taxable, regardless of where it is located at the time of the decedent’s death.

In the case of a nonresident decedent, all real property and tangible personal property located in Pennsylvania at the time of the decedent’s death is taxable. For example, if your client inherits two houses from his grandfather, who lived in another state, and one house is in PA, then your client will pay taxes only on the house in PA.

Jointly-held property with right of survivorship (except between spouses) is taxable to the fractional percent of the ownership. For example, if your client owns 25% of a business, he pays inheritance taxes on 75% of the asset. However, if your client was named as joint owner within a year of the person’s death, it is taxable at 100%.

• Direct descendants (lineal heirs): 4.5%

• Siblings: 12%

• Other heirs: 15% (except tax-exempt charities, exempt institutions, and government entities)

Inheritances generally do not affect subsidies such as healthcare through Pennie, since Pennie’s eligibility is calculated based on modified adjusted gross income (MAGI), which does not include inheritance as income. However, future income generated from assets, such as dividends or rent, would affect Pennie, and an inherited pension or IRA may also need to be reported in part as income.

Inheritance taxes are due nine calendar months after the death of the decedent; therefore, it is critical to move quickly. Communicate to all your clients the importance of contacting you immediately upon being informed of an inheritance in order to avoid penalties for late payment. Assure them that you can help them navigate the complicated inheritance tax process and limit their tax burden as much as possible.