First, the good news -- inherited property isn’t taxable. Someone might leave you $1 million in cash, but you wouldn’t have to share a dime with the Internal Revenue Service -- at least not right away. The same applies to real property, investments and even retirement accounts. Until you do something with the asset, such as sell it, cash it in or just let the cash grow, the initial inheritance is tax-free. If the inheritance generates income, reporting this depends on what you inherited.
If you sell your inherited property, there’s a chance you’ll owe capital gains tax. You must pay this tax on the difference between the cost of acquiring an asset – called your basis -- and the sales price. If you purchase a property for $200,000 and sell it for $300,000, you’d have a $100,000 taxable capital gain. But you catch a bit of a break with inherited property.
It's a Long-Term Gain
Even if you sell it the day after you receive it, the IRS considers an inheritance a long-term capital gain, which for taxpayers is a good thing. The tax rate can be much less than a short-term gain, which is taxed as ordinary income at your regular tax rate. You must hold all other assets a year before they qualify for long-term tax treatment.
The Basis of Inherited Assets
You don’t have to go all the way back to the time the deceased purchased the asset to determine your basis, which also benefits you at tax time. If he bought a home in 1955, it’s going to be worth a lot more now than it was then, resulting in a larger gain and more taxes due. But the IRS says you can use the value as of the deceased’s date of death instead of what he paid for it. This value would typically be a great deal more, cutting away at the difference between the sales price and your basis. You can calculate your gain on IRS Schedule D and report the resulting figure on line 14 of Form 1040.
Interest and Dividends
If you take that $1 million cash inheritance and plunk it down in an investment account – or even a run-of-the-mill savings account – it’s going to start generating interest. This is income to you, so you'll owe taxes on it. You must report it on line 8a of your 1040. If it amounts to $1,500 or more, you must complete and submit Schedule B,-Interest-and-Ordinary-Dividends) as well. The same applies to dividends resulting from investing the money, which go on line 9 of the 1040.
You might want to consult an accountant or tax professional if you inherit a retirement account such as an IRA or 401k. Tax rules for these assets can be tricky. Taxation depends on whether the deceased contributed to the accounts with pre-tax or after-tax money. In either case, however, it’s not taxable until you take a distribution. Taxable retirement income goes on line 15b or 16b of your 1040.
You might not be done reporting inherited property when you finish your federal tax return. Although the IRS doesn’t impose an inheritance tax, a few states do. Check with a local tax professional to find out if your state is one of them. The list of states with an inheritance tax changes periodically, so you’re best off touching base with someone in the know to make sure you have the most current information.