Avoid this potential tax headache
If you are expecting to inherit property when friends or relatives pass away, know that their generosity can come with tax consequences. It’s important to understand how the value of your inheritance is determined to avoid a potential tax surprise in the future.
Estate tax basics
When a friend or relative dies and leaves behind a will, someone will be named the executor of their estate. The term “estate” means the total amount of the assets and liabilities the deceased person leaves behind, and the “executor” is the person named to handle the affairs of the estate. It also includes managing the distribution of remaining assets to “beneficiaries,” which is another word for the people who inherit the assets.
The executor has the responsibility to calculate the value of the assets, generally on or around the date of death. This is called the “stepped-up basis.” If the total value of the estate is worth less than $5.49 million, the estate pays no federal tax. If it’s more than that amount, the IRS’s piece of the pie scales up to a whopping 40 percent. Thirteen states and the District Columbia also collect state estate taxes of as much as 20 percent.
The conflict over value
Generally speaking, executors would rather have the estimated value of an estate’s total property fall below estate tax thresholds. But as a beneficiary receiving an inheritance, it’s in your interest to have a higher estimate of value. That way you may avoid higher capital gains tax if you sell the property.
A high estate valuation helps you as a beneficiary because you only pay tax on the increase in value from the “stepped-up basis.” So, if your inherited property was valued at $200,000 and you later sell it for $300,000, you would pay taxes on $100,000. But if the same property was valued at $300,000, you would potentially owe no tax.
A matter of value
In valuing a piece of property, an executor will compare it to similar properties that have recently sold. Ideally, there is a qualified appraisal by an expert to determine the “fair market value.”
If you disagree with the way an executor has valued property you are inheriting, it may be a good idea to have your appraisal done. With your appraisal in hand, reach out to the executor and make your case for the higher valuation based on your appraisal. Keep in mind that you don’t want an evaluation that is either too low or too high — you want a reasonable, fair market value of the assets. If you don’t talk to the executor and you end up using a different valuation in reporting to the IRS, you could be facing a big tax headache.
If you’re able to talk to the executor and agree on a valuation, consider asking for a Form 8971 Schedule A. This form itemizes the valuation of property and is now often required by the IRS for estates worth more than $5.49 million. However, it can also be used to provide you with documentation showing that you and an executor have reached an agreement on the value of a specific piece of inherited property.