Inheritance raises tax questions
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Today I answer two questions related to inheritance:
Dear Dr. Don,
My husband and his sister inherited money and other property after their father’s death last year. What is their basis in the money they received from his retirement funds, IRAs, stocks, sale of his house, etc.?
— Flummoxed Flo
The assets are valued either at the date of his death, or six months later (if the executor elects the alternate valuation date, or AVD).
If the AVD is elected, assets sold or distributed after death but before the alternate valuation date are valued as of the sale or distribution date. Your father-in-law’s beneficiaries receive the assets with a basis equal to the fair market value the assets had at the relevant valuation date. This is called a step-up in basis.
If and when the beneficiaries sell the assets, the capital gains or capital losses are calculated using the stepped-up basis. It’s important to note that distributions from inherited tax-deferred retirement accounts like a traditional IRA or 401(k) account are taxed as ordinary income, so the step-up in basis isn’t germane to these accounts.
As beneficiaries of the retirement funds and IRAs, your husband and sister may still have some options available to them in how the accounts are titled or converted. This can give them some flexibility in how they take distributions or chose beneficiaries for the accounts. They need to consult with their tax professionals, especially about these options.
Note: Thanks and a tip of the hat to Connie Fontaine — associate professor of taxation and the Larry R. Pike chair in insurance and investments at The American College in Bryn Mawr, Pa. — for helping me understand the issues involved in this reader’s question.
Dear Dr. Don,
I recently inherited $25,000 and I was trying to figure out how to make the most of it. I have some home repairs that are needed, but should I invest/use it in a certain way as to avoid capital gains or taxes?
— Ruby Reconnoiter
Any estate taxes due were paid by the estate before you inherited. As discussed in my reply to “Flummoxed Flo” above, the tax cost basis of inherited assets is stepped up to the asset valuation at the decedent’s death or alternate valuation date. Your capital gain (loss) is determined by the gain (loss) in value when you sell the asset compared to the stepped-up basis.
Distributions out of inherited tax-deferred accounts are taxed at ordinary income levels. Consult with a tax professional, if you haven’t already, if you inherited retirement funds or an IRA account.
For accounts that aren’t tax-deferred where you have a step-up in basis, you’re only worrying about the taxation of recent gains (losses). Because you inherited, the assets any gains or losses are treated as long-term but a recent inheritance should mean that there’s not much of a tax impact in your selling these assets.
Home repairs protect the value of your real estate investment. It’s hard to justify delaying needed maintenance projects when you’ve got the money to invest in those repairs. Keeping some money in reserve for an emergency fund is one reason not to spend all the inheritance on home repairs.
Managing the tax impact of selling investments is an important part of making investment decisions, but don’t let it be the tail wagging the dog. Look at where the money is invested now and compare it to what you can earn elsewhere, including an investment in home repairs.