Most folks receiving an inheritance are as alarmed over taxes as they are elated about their newfound wealth. Is it taxable? The short answer is “maybe.” There are two possible taxes. The first is the estate tax, which applies when wealth (exceeding specified amounts) is transferred at death. It is reported on IRS Form 706, Oregon Form IT-1 and Washington Form 850049e. The second is the income tax, which attaches to a very narrow scope of assets. It is reported on federal forms 1041 and 1040, and Oregon forms 41 and 40. (Washington has no income tax.)
Estate Taxes (Taxes Triggered by Death)
The money and property owned by an individual at death is commonly referred to as the “estate.” If sufficient in amount, a tax (commonly known as the “estate tax”) may be imposed on the decedent’s estate. The tax, if any, is paid by the executor of the estate “off the top” before any distributions are made to beneficiaries named in the will. Thus, with a few exceptions, the amounts received by the beneficiaries are net of any estate tax.
Federal Estate Tax (Paid to the IRS). In general, a single individual may transfer up to $5 million of wealth at death without incurring any federal estate tax. In general, wealth passing to a spouse or a charity is always exempt from estate tax, and doesn’t count toward the $5 million. For example, if Bill Gates transfers all of his property to Melinda Gates and the Gates Foundation at his death, there will be no estate tax owing at that time. For a married couple, the exemption is effectively $10 million. Thus, federal estate taxes are often irrelevant. [Technically, the federal exemption drops to $1 million per spouse on January 1, 2013, but it is likely Congress will extend the present $5 million exemption.]
Oregon Estate Tax. Oregon’s estate tax is based on federal law, except that the Oregon exemption is currently only $1 million per individual. The tax on the excess over $1 million depends on whether the death occurs in 2011 or 2012. For deaths in 2011, the computation is dysfunctional: the layer of wealth between $1 million and $1,093,785 is taxed at 41%, and the excess is taxed at rates starting at 5.6% and gradually moving up to 16% for estates over $10 million. If the death is in 2012, the excess over $1 million is taxed at rates starting at 10% and gradually increasing to 16% for estates over $9.5 million. The modest Oregon and Washington exemptions often necessitate tax planning even when there is little likelihood of federal death taxes.
Washington‘s Estate Tax. Washington’s estate tax is also based on federal law, except that the exemption is $2 million per individual. The excess over $2 million is taxed at rates starting at 10% and gradually increasing to 19% for estates over $9 million.
Income Taxes Payable When Inherited Property is Sold
All of us must keep track of the original cost of our property so that we can determine the gain or loss when it is ultimately sold. There is a special rule for a decedent’s property, which takes on a new cost basis equal to its fair market value on the date of death. Thus, if I buy IBM shares for $200 and hold them until I die, when they are worth $900, the cost basis increases to $900, and my heirs can sell them for $900 without any gain or loss. There are a few exceptions. There is no cost basis adjustment on items representing deferred income, such as IRA accounts and accrued US Savings Bond interest.