Attorney Ted Brown
As a probate and estate administration attorney at Cooper, Adel & Associates, I frequently deal with family members who have recently received, or about to receive, an inheritance from a relative. The prevailing question on everyone's mind is whether they need to report this inheritance on their taxes. The short answer is “no.” Under Section 61 of the Internal Revenue Code, an inheritance is not considered “income” and is therefore not taxable as such.
Generally, an inheritance is taxed as part of the State or Federal Estate Tax, which is typically calculated and paid before beneficiaries receive distributions. The Estate Tax is commonly known as the “death tax” or “inheritance tax.” Since the estate is taxed before the beneficiaries receive their share, anything going to them is not taxable.
However, as with any IRS rule, there are exceptions. The two biggest are tax-qualified retirement plans and the sale of inherited real estate. Distributions taken from tax-qualified plans (such as a traditional IRA or 401K) passed to a beneficiary are taxable as income to the beneficiary in the year they are taken. When real estate that was inherited is sold, the beneficiary will owe capital gains tax on the sale (unless it has been their primary residence for 2 of the last 5 years).
The other thing to keep in mind is that even though you may not have to report your inheritance on your income taxes, it may still be subject to the unpaid debts, claims and taxes of the decedent. This is why it is important for the Executor or Successor Trustee to make sure that all debts and expenses are paid before distributions are made.