Does an Inheritance Count as Income?

An inheritance often brings questions about its financial implications, particularly whether it counts as taxable income. While the direct answer is generally no for federal income tax purposes, beneficiaries should understand several important nuances. This article aims to clarify the tax treatment of inheritances, distinguishing between the inherited principal and any income it subsequently generates, along with other related taxes.

Income Tax on the Inheritance Itself

The principal amount or value of an inheritance, whether cash, real estate, or investments, is not subject to federal income tax for the recipient. This fundamental aspect differentiates an inheritance from earned income, such as wages or business profits. Instead, the Internal Revenue Service (IRS) considers inheritances as transfers of wealth rather than taxable income to the beneficiary.

This means that if you inherit a sum of money, a house, or a portfolio of stocks, you will not owe federal income tax on the value of these assets when you receive them. The exemption applies to the initial transfer of assets from the deceased person’s estate to the heir.

Taxation of Income from Inherited Assets

While the inherited principal itself is not taxed as income, any earnings generated by those inherited assets after you receive them are subject to income tax. This distinction is crucial for beneficiaries managing their inherited wealth. For instance, if you inherit a savings account, any interest it accrues after the decedent’s death becomes taxable income to you. Financial institutions report interest income on Form 1099-INT.

Similarly, dividends received from inherited stocks or mutual funds are taxable. These amounts are reported to you and the IRS on Form 1099-DIV. If you inherit rental property, any rental income collected from that property after the inheritance date is also considered taxable income. Royalties from inherited intellectual property, such as copyrights or patents, also fall under this category. This income is taxed at your ordinary income tax rates.

Understanding Basis and Capital Gains

When you sell an inherited asset, the tax implications depend on its “basis,” which is essentially its value for tax purposes. For inherited property, the basis is the fair market value of the asset on the date of the decedent’s death. This rule, known as “stepped-up basis,” can provide a tax advantage.

Stepped-up basis means that the asset’s cost basis is adjusted to its fair market value at the time of the previous owner’s death, rather than their original purchase price. This adjustment can substantially reduce or even eliminate capital gains tax if the asset is sold shortly after being inherited. For example, if your parent bought stock for $10,000 and it was worth $100,000 when they passed away, your basis becomes $100,000. If you then sell it for $105,000, your taxable capital gain is only $5,000, not $95,000.

Inherited assets are considered to have been held for more than one year, regardless of the actual holding period by the decedent or the beneficiary. This means that any capital gains on inherited assets, once sold, are taxed at the more favorable long-term capital gains rates. This provides an additional benefit compared to assets held for a shorter duration, which are subject to higher short-term capital gains rates.

Distinguishing Other Taxes from Income Tax

It is important to differentiate federal income tax on beneficiaries from other taxes that may apply to an inheritance. The federal estate tax is levied on the deceased person’s estate itself, not on the beneficiary’s income. This tax applies to the total value of the decedent’s assets before they are distributed to heirs. The federal estate tax has a high exemption threshold, meaning only large estates are subject to it.

For 2024, the federal estate tax exemption is $13.61 million per individual, increasing to $13.99 million for 2025. This exemption amount limits the number of estates that owe federal estate tax. The tax rate on amounts exceeding this threshold can be as high as 40%. Due to this high exemption, most estates do not incur federal estate tax.

In addition to federal taxes, a few states impose an inheritance tax, which is distinct from federal income tax. Unlike the federal estate tax, state inheritance tax is paid by the beneficiary, not the estate. The applicability of this tax depends on the specific state’s laws and often the beneficiary’s relationship to the decedent. Most states do not have an inheritance tax, so many beneficiaries will not encounter this levy.

General Reporting Considerations

While the inherited principal does not need to be reported as income on your federal income tax return, any income generated by the inherited assets must be. Interest income will be reported on Form 1099-INT, and dividends on Form 1099-DIV. Financial institutions send these forms to you.

If you sell inherited assets, the transaction details are reported on Form 8949, Sales and Other Dispositions of Capital Assets. The totals from Form 8949 are then transferred to Schedule D, Capital Gains and Losses, which is filed with your individual income tax return, Form 1040. If the inherited assets were held in a trust or estate, you might also receive a Schedule K-1, which reports your share of any income, losses, or deductions from that entity. Maintaining accurate records of inherited assets and their fair market value at the time of inheritance is important for future tax reporting.