Understanding how inheritances are taxed is essential to maximize the benefit you provide your heirs. It is also important to know if you are receiving an inheritance and wish to maximize your own benefit. One of these taxes is the inheritance tax on property.
Proper estate planning requires a firm understanding of the inheritance tax and what differentiates it from other taxes, such as the estate tax. Further, you should know who pays the inheritance tax and how it is calculated. Finally, there are several strategies to minimize the inheritance tax on property. Each method comes with its advantages and disadvantages. Choosing the plan that best fits your circumstances is vital.
At Batson Nolan PLC, we know how to plan for estate and inheritance taxes. Our skilled attorneys will work with you to lower your estate’s tax burden and maximize the benefit you can provide. Schedule a consultation today.
What Is an Inheritance Tax?
An inheritance tax is any tax levied against the recipients of inherited assets. While relatively rare in the United States, some states impose this tax on some or all recipients of inherited property. These taxes are usually based upon where the person passing on assets (the decedent) lived and must be paid by anyone receiving an inheritance from their estate.
For example, take the case of a homeowner (Jeremy) who bequeaths a house to his friend (Jo), who lives in another state. Jeremy lives in Kentucky. Jo lives in Colorado. Since Kentucky levies an inheritance tax, Jo must pay the tax to the relevant jurisdiction in Kentucky within a year of receiving the property. This is despite the fact that she lives in Colorado, a state that has no inheritance tax.
Difference Between an Inheritance Tax and Other Taxes on Estates
The inheritance tax on property is different from other estate taxes. First, most estate taxes are paid by the estate before any property is passed on to heirs. This procedure helps minimize the unexpected tax burden an heir will face after the death of a loved one. While there is a federal estate tax, there is no federal inheritance tax.
Further, an inheritance tax differs from other taxes paid by heirs, such as the capital gains tax on inheritance. An inheritance tax is usually based on the entire property value and must be paid within a year. The capital gains tax is based upon the increase in value between when the heir receives the property and when they sell it—and is only paid when the heir sells the property in question.
Inheritance Property Tax in Tennessee
Fortunately, Tennessee does not levy an inheritance tax on inherited property. However, residents should still understand inheritance taxes because many Tennessee families have close friends and family in Kentucky. Therefore, if Tennesseans become heirs of a Kentucky resident, the Kentucky inheritance tax will be relevant.
How Is Inheritance Tax on Property Calculated?
How you calculate a given inheritance tax can differ based on the jurisdiction levying the tax. On the lower end, inheritance taxes can start at around 1% of a property’s value. In some jurisdictions, these taxes can go as high as 16%. Some states have a flat rate, while others base the tax rate on the property’s value, the relationship between the decedent and the beneficiary, or both. In all U.S. jurisdictions that impose an inheritance tax, the amount a taxpayer owes is based on the value of the inherited property.
When it comes to understanding how an inheritance property tax is calculated, examples are helpful. Take, for instance, Kim and Tom. Kim lives in Kentucky, and Tom lives in Tennessee. Kim leaves a $21,000 property to Tom in her will.
Kentucky bases the inheritance tax rate on the relationship between Kim and Tom and the property’s value. Since Tom is Kim’s nephew, he is a Class B beneficiary in Kentucky. Therefore, the first $1,000 of his inheritance is exempted, and he faces a potential tax rate of between 4% and 16%.
The value of the property minus the exemption is $20,000. The tax rate on the property’s value up to $10,000 is 4%, and the tax rate for the next $10,000 is 5%. Therefore Tom must pay taxes of $400 on the first $10,000 of value and $500 on the second. His total tax burden is $900 for the $21,000 inherited property.
An inheritance tax return should be included in Tom’s tax return for the year he received the property.
Exemptions and Deductions in Tennessee
Since there is no inheritance tax on property in Tennessee, no specific exemptions or deductions are available to Tennessee residents. However, an experienced tax attorney from Batson Nolan can work with you to minimize your overall tax liability.
Who Pays Inheritance Tax on Property?
The nature of an inheritance tax means that the person receiving the inheritance is the one who must pay. However, in some states, people who have a close familial relationship with the decedent owe a lower amount or nothing at all.
Using Kentucky as an example, beneficiaries are separated into three classes. Class A beneficiaries include:
- Siblings, and
- Half siblings.
Beneficiaries in this class are fully exempt from paying an inheritance tax.
Class B beneficiaries include:
- Aunts and uncles,
- Nieces and nephews,
- Half-nieces and half-nephews,
- Sons-in-law, and
- Great grandchildren.
This class of beneficiary is taxed the same as Tom in the preceding example.
Finally, Class C beneficiaries include those not mentioned as Class A or B. These individuals get a $500 exemption and face a 6% to 16% tax rate on inherited property.
States use different formulas to determine who pays an inheritance tax and how much. If you are inheriting property from a decedent in a state that collects an inheritance tax, call Batson Nolan today, and we can help you fully understand the tax implications.
Strategies to Minimize Inheritance Tax on Property
There are several ways to minimize the inheritance tax paid on a property. However, each of these strategies requires careful planning and must be put in place before the heir inherits the property. In other words, if the decedent was diligent in considering tax implications while planning how their estate would pass upon their death, their heirs would likely pay far fewer taxes.
One way to avoid making your heirs pay an inheritance tax is to move to a state that does not levy one. This is usually the least desirable strategy and can be complicated if you still intend to own property within the state.
Another strategy is to give your beneficiaries gifts before you pass. Gifts are exempt from taxation up to a certain amount every year. Giving now can help get beneficiaries money or assets when they most need it. Doing so also helps minimize their overall tax burden. The major drawback to giving gifts is that you can only give up to a certain amount without triggering taxation.
A third option is setting up a life insurance policy for beneficiaries. In most cases, life insurance payouts are not subject to inheritance taxes. The major disadvantages of life insurance policies are that they can be expensive and complicated to set up, and not everyone will qualify for one.
Create a Trust
Finally, establishing a trust is one of the most effective ways to avoid probate and inheritance tax. Putting your assets in a trust will give you control over how they are distributed and the ability to plan for any taxes that must be paid. However, establishing a trust can be complicated, so you should speak with an attorney before forming one.
Is Inherited Property Taxable Income?
No. The federal tax code does not consider inherited property income for tax purposes. There is also no inheritance tax or estate tax in Tennessee. However, the federal government imposes an estate tax of 18% to 40% on most estates larger than $12.92 million in value. It is also important to note that any gains on inherited assets can be taxed as capital gains when the assets are sold.
What Is the Tax Basis for Inherited Property?
The tax basis for an inherited property pertains to the taxes owed on gains when selling the property and not to an inheritance tax. In most cases, the basis for inherited property is the property’s fair market value on the date of the decedent’s death. In other words, you will only be taxed on gains above and beyond that value if you decide to sell the property.
Can I Avoid Inheritance Tax on My Parent’s House?
Depending on the state levying the tax, you may not owe any taxes on assets inherited from a parent, to begin with. Otherwise, tax law can be specific and nuanced. It is best to discuss your options with an attorney.
What Is the Most I Can Inherit Without Paying Taxes?
The amount you can inherit without paying taxes depends upon the specific tax at issue. An experienced inheritance tax attorney from Batson Nolan can help you understand how a particular inheritance will be taxed.
Batson Nolan Can Help
The attorneys at Batson Nolan PLC know what to do if you are facing a significant inheritance tax burden or trying to set your beneficiaries up for success. We can help you understand the inheritance tax, estimate how much it might be, forecast who will pay it, and create a personalized strategy to minimize your estate’s tax burden. Our attorneys pride themselves on their close ties with clients and their reputation for outstanding legal work. Contact us today, and we will work with you to accomplish all your estate planning goals.