What are the income tax ramifications of property inherited from a decedent’s estate? What are the cost basis issues for an individual beneficiary/heir receiving inherited property? This is an important area sometimes overlooked by executors and beneficiaries. It can be incorrectly assumed that all inherited property receives a step up in basis to the fair market value of the property at the date of the decedent’s death.
It is true that under the general rule of Code Section 1014(a)(1) the cost basis of property acquired from a decedent, which has not been sold, exchanged, or otherwise disposed of before the decedent’s death, is stepped up (or down) to the property’s fair market value at the date of the decedent’s death. There is an exception if the executor of the estate elects, for estate tax purposes, to value the decedent’s gross estate at the alternative valuation date. (IRC Section 2032). The basis of property in a beneficiary’s hand in that case would be the fair market value at the appropriate alternative valuation date. The alternative valuation date is the date six months after the decedent’s death, or if the property has been distributed within six months, then the alternative valuation date is the distribution date. If no estate tax return is required to be filed, the alternative value date is not applicable pursuant to Regulation 1.1013-3(a) because of the lack of an election. Even without an estate tax return the rule of Code Section 1014(a)(1) controls, that is, the cost basis of property in the hands of the beneficiary will be the fair market value of the property as of the date of the decedent’s death.
It is crucial that cost basis and gifting rules be understood so that disastrous tax errors are not made. For example, mistakes are often made when property is gifted to a family member prior to death. In lifetime gifting the beneficiary takes the donor’s cost basis and the step up rules do not apply. There can be serious income tax ramifications on the eventual sale of gifted property by the donee.
In some instances proper estate planning, beyond normal annual gifting considerations, does call for a lifetime gift of an asset. Wealthy taxpayers may wish to gift investments that have strong indications of asset value increases. The logic is to reduce the taxable estate of the donor and/or shift income taxes to family members in lower tax brackets.
The gift tax rules are different than a decedent step-up in basis rules. When property which has gone down in value is the subject of a gift, the donee will take the date of gift as his cost basis. This is compared to a gift where the property has gone up in value in which the donee must take the donor’s cost basis as his cost basis for income tax purposes. Generally the best plan for property which is declining in value is for the owner to sell it before death so that he can enjoy the full tax benefit of the capital loss. This unusual rule may require special planning when some assets have decreased in value for a wealthy, but failing, taxpayer who has a mix of assets with varying amounts of unrealized gain and loss.
Family members must also be aware of Code Section 691(a)(1) IRD rules which can come as a surprise to individuals inheriting property. There are special tax rules applicable to items of income producing property received by a beneficiary known as “Income With Respect To A Decedent” or “IRD”.
Certain property inherited by a beneficiary is not includable as taxable income on a beneficiary’s tax return (Form 1040) e.g., cash, securities, mutual funds and real estate. Items of IRD, however, must be included in the beneficiary’s taxable income at some point.
What is IRD? IRD is income which the decedent (the person from whom you inherit the property) would have taken into taxable income on his income tax return except that death interceded. A common IRD item is a decedent’s last paycheck received after death – although sometimes included on the decedent’s last income tax return; however, since the decedent’s tax year closed as of the date of death, payroll checks theoretically are not included in the decedent’s last Form 1040 return. Not only are paychecks subject to this rule, but any item employer compensation related benefits paid after death are considered IRD. This includes accrued vacation pay and voluntary employer benefit payments which will be subject to IRD reporting. Such employment items can be picked up as taxable income on the estate income tax return (Form 1041) of the decedent because many estates have significant settlement costs and attorney fees offsetting the estate’s income subject to income taxes.
Other common IRD items include pension benefits and amounts in decedent’s individual retirement account (IRA’s) at death as well as the decedent’s share of partnership and LLC income.
If an heir receives specific IRD items, the income is to be included as taxable income on Form 1040 in the year the income was paid to the beneficiary. This is true for those beneficiaries/heirs who are income beneficiaries under the will or designated retirement beneficiaries, by contract, or under local law. A common example is an inherited IRA or 401(k) which is eventually received as cash by a beneficiary.
Decedent’s deferred employee compensation which the decedent elected to defer under an employer’s deferral compensation plan is IRD. Shares of stock in the employer corporation that had been payable to the decedent as a result of his exercise of compensatory employer stock options also fall under the IRD rule. So are stock options vesting at the decedent’s death.
Here is a list of common IRD items which must be reported on an income tax return – either Form 1040 of the beneficiary or Form 1041 (estate income tax return):
- Decedent’s employer compensation related benefits paid after death.
- Decedent’s Individual Retirement Accounts (IRAs) on withdrawal.
- Company or government retirement plans which have yet to be subject to income tax such as 401(k)s and 403(b)s – any qualified retirement plan which is liquidated. Again, on withdrawal or distribution.
- Annuity contract payments to beneficiaries in excess of the decedent’s cost basis.
- Certificate of Deposit interest.
- U.S. Treasury Bond interest.
- Generally life insurance proceeds are not taxable to the beneficiary. In the normal case life insurance proceeds are paid under third party (institutional) life insurance policies which, by operation of Code Section 101
- (a), are not taxable income to the beneficiary. On the other hand, if it is the employer corporation paying a death benefit to the employee’s estate or designated beneficiary then the proceeds may be considered deferred compensation of the decedent and be classified as IRD. The question is: Who is paying premiums for the death benefit? Employer death benefit proceeds may be deferred compensation IRD income.
- Payment on accounts receivable of the decedent.
- Payments on decedent installment agreements having post death payments.
A possible IRD tax deduction exists. Although IRD is usually included on the income tax return of the income beneficiary, an income tax deduction may come along with it. This deduction is allowed (as an itemized deduction on the recipient’s Schedule A Form 1040) to lessen the “double tax” impact caused by having the IRD item subject to both the decedent’s estate tax (either federal or state or both) as well as recipient’s income tax return. The computation is complex but essentially means that the recipient beneficiary will have a deduction for estate taxes paid on the value of the asset includable in the taxable estate of the decedent. Basically it amounts to a pro rata tax deduction for the amount of estate tax paid by the decedent’s estate on the very same IRD asset.
One of the most difficult tasks faced by an executor of a sizable estate is the complexity in planning distributions from the estate to the beneficiaries; there are a plethora of complex rules, which, to the uninitiated, may be missed. Here are some of the basic planning strategies and objectives:
- Splitting of the estate’s IRD assets amongst the largest possible number of estate beneficiaries (heirs) with the view to having the income taxed at lower marginal rates (Form 1040) than if paid by the estate itself (Form 1041) or if distributed in larger sums to fewer beneficiaries.
- Selection of a tax year for the estate (non-calendar year) for the purpose of deferring recognition of income tax to beneficiaries. With proper planning recognition of income on IRD items in the fiscal (and different) taxable year of the estate will provide the estate income tax return (Form 1041) with a “distributable net income” to be reported by the beneficiaries the following year. Tax deferral is the result.
- In some cases there may be an advantage in having a particular beneficiary receive income producing assets. The beneficiary may be in a position to offset capital gains or have a significantly lower income tax bracket than other beneficiaries. A plan can be prepared to address overall family minimization of income taxes.
An individual who is receiving an inheritance should be aware that there can be income tax burdens with property inherited from a decedent. This is an important area often overlooked when families are addressing final affairs of decedents with an investment portfolio including IRD assets. The executor should retain the services of an income tax professional to minimize and defer income tax obligations and to maximize the after tax transfer of wealth from one generation to another.