Important considerations when receiving an inheritance

Receiving an inheritance can be a bittersweet experience for someone in the midst of grieving the loss of a parent or other loved one. While most beneficiaries may not be surprised to learn that they are inheriting assets, they may not be aware of the implications of receiving an inheritance. Depending on the type of assets inherited, there are various tax consequences and other rules dictating how a beneficiary can receive and use those inherited assets.  

Part I: Understanding the nature of assets you inherit

Tax aspects of inheritance

Inheritances have favorable income tax consequences for a beneficiary. With limited exceptions (such as pre-tax retirement accounts and unpaid wages due to a deceased person) a beneficiary does not pay income tax on an inheritance.  As well, most inherited assets receive an income tax basis adjustment (sometimes called a “step-up”) so that if and when the beneficiary sells the inherited asset they do not pay any capital gain tax on the difference between what the deceased person paid for the asset and what it was worth at the date of death.

Many beneficiaries are also concerned about estate tax. Estate tax – if due – is generally paid by the executor or trustee handling the deceased person’s estate before the beneficiary receives the inheritance. This may, in some circumstances, reduce what the beneficiary ultimately receives, but once the beneficiary receives it they are not subject to any additional tax obligations.

Practical realities of inheritance

Receiving an inheritance may take several months (or in more complicated situations longer) after a loved one’s death. Below are some of the practical issues and considerations when common types of assets are distributed in-kind to beneficiaries.

1. Cash and securities

Cash and securities tend to be the most straightforward assets to inherit in that they are liquid and easily transferable.  Usually, the executor or trustee handling the deceased person’s estate  needs to provide the bank or financial institution with instructions for the transfer.

2. Real estate 

Inheriting real estate can be a boon to beneficiaries, especially in California where real estate is highly coveted.  However, inheriting real estate can come with hidden costs and complexities, such as:

• Property taxes – Property taxes are one of the biggest factors to consider when inheriting real estate. With the passage of Prop 19 on February 16, 2021, the property tax benefits of inheriting real estate from a parent in California were largely eradicated.  This can result in skyrocketing property taxes that an inheriting beneficiary cannot afford.  Details on Prop 19, including the remaining exemptions post-enactment, can be found here.

• Mortgages – Unless the deceased person’s estate plan says otherwise, real estate that is subject to a mortgage is transferred to the inheriting beneficiary subject to the mortgage.   The beneficiary then has the option to (1) assume the mortgage, (2) pay off the mortgage with the beneficiary’s other funds, or (3) sell the property to pay off the mortgage.  It is important to note that family members inheriting real estate are provided certain protections under federal law which bar lenders from requiring immediate mortgage repayment when residential real estate with four units or less is transferred to certain relatives.  In any event, it is important that mortgage payments continue to be made to avoid defaulting on the loan.
• Co-ownership – In some instances, real estate is gifted to more than one beneficiary. Co-ownership of real estate requires consideration by the inheriting beneficiaries as to who will live in or manage the property, how expenses and taxes will be paid going forward, and whether the parties want to enter into a partnership or other legal entity to own the property and institute a central management system.   Co-ownership of real estate can result in conflict if the inheriting beneficiaries disagree on any aspect of ownership. In some cases, it may make sense for one beneficiary to buy out the others if they are able.  

3. Retirement assets

The rules for inheriting a retirement account, such as an IRA or 401(k) account, are complex and must be considered on a case-by-case basis depending on the relationship between the deceased person and the beneficiary, the age of the deceased person at death, and other specifics pertaining to the beneficiary.  Notably, retirement accounts do not get the benefit of a step-up in basis. Generally, unless certain exceptions apply (such as for a spouse), a beneficiary is required to withdraw the entirety of the account within no more than 10 years of the deceased person’s death. If the account owner died after reaching the age for which required minimum distributions (“RMDs”) are mandated, the beneficiary could also be required to take those RMDs. As noted above, distributions from a retirement account are taxed as ordinary income to the beneficiary (except in the case of certain Roth accounts).   Moreover, if a trust was named as the beneficiary of a retirement account, there are specific deadlines to open an inherited account in the underlying beneficiary’s name and then to subsequently transfer the accounts. Details on the exceptions to the ten year withdrawal rule can be found here.

4. Interests in closely held businesses

Inheriting interests in a family business or other closely held business can also be complicated depending on the terms of the governing documents for the business and other tax attributes of the entity in which the business is held.  For example, the business could have a buy-sell agreement among its shareholders to provide that upon the death of one of the shareholders, such shareholder’s interest must be offered to the other shareholders to purchase before the interests are transferred to other parties.  Governing agreements often include restrictions on the rights of members to withdraw their interests which are subject to the manager’s discretion, meaning that liquidating the inheriting beneficiary’s interest can be out of the beneficiary’s control.  While interests in entities typically can get a step-up or step-down in basis, depending on the type of structure (such as a partnership) the basis treatment can differ and require an experienced accountant to provide guidance.  Lastly, if the business is treated as an S-corporation, the laws limit the amount of time in which a deceased person’s estate or trust can continue to be a shareholder (generally, 2 years after death) without jeopardizing such status. As a result, it is critical to be mindful of deadlines in transferring such interests to the inheriting beneficiaries.      

This article is authored by Susanna Kim.