Inheriting a property is great, but it comes with the responsibility of paying taxes. You can reduce your property tax by understanding how inheritance tax works and how to take advantage of it.
In this article, you will understand all you need to know about inheritance tax: definition, overview, and how it works.
What is inheritance tax?
An inheritance tax is a tax paid by one or more people who inherit the estate (money or property) of a deceased person. In some jurisdictions, the terms “estate tax” and “inheritance tax” may be used interchangeably.
In the UK and some Commonwealth countries, the tax is also known as a ‘death tax’ but not in the legal context.
The tax is not common in the US, and whether or not it applies in one of six states with an inheritance tax beginning in 2022 depends on the state where the deceased lived or owned property, the value of the inheritance, and the relationship of the beneficiary to the testator.
In the United States, the federal government collects the estate tax, while the state government collects the inheritance tax. Both work on the same principle.
With inheritance tax, a person designated in a statutory will as the heir to assets from an estate may be required to pay taxes to the state. This is not the same as taxes being levied on the property itself, only due to the right to take ownership.
The inherited property is assessed and a tax may or may not be levied depending on the appraised value and the relationship of the heir to the deceased owner.
How to Understand Inheritance Tax
Inheritance tax is not the same as inheritance tax. An inheritance tax is levied on the estate itself prior to the distribution of the estate, while an inheritance tax may be imposed on the beneficiaries of the estate.
There is no federal inheritance tax in the United States. While the U.S. government directly taxes large estates—by levying estate taxes and, where applicable, income taxes, on all income from the estate—it does not levy an estate tax on those who receive assets from an estate.
Estate taxes are levied by six US states Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania.
Whether your inheritance is taxed and at what rate depends on its value, your relationship with the deceased, and the rules in force where you live.
There is normally no inheritance tax payable if either:
• The value of your estate is below the £325,000 threshold.
• You bequeath anything over the £325,000 threshold to your spouse, domestic partner, charity, or local amateur sports club.
• Your threshold can increase to £500,000 if you give away your home to your children (including adopted, foster or stepchildren) or grandchildren.
• If you are married or in a civil partnership and your estate is worth less than your threshold, any unused threshold may be added to your partner’s threshold on your death.
This means their threshold can be as high as £1 million.
Also see, What Is Tax Underpayment Penalty?
How are inheritance taxes calculated?
Any inheritance tax that may arise is only levied on that part of an inheritance that exceeds a tax-free allowance. Above these thresholds, the tax is usually fixed at a flat rate.
Interest rates typically start in the single digits and go up to 15% to 18%. Both the exemption you get and the rate you’re charged can vary based on your relationship with the deceased – even more so than the value of the assets you inherit.
As a rule, the closer your family relationship is to the deceased, the higher the allowance and the lower the tax rate to be paid. Surviving spouses are exempt from inheritance tax in all six federal states.
Life partners are also exempt in New Jersey. Descendants are subject to an inheritance tax only in Nebraska and Pennsylvania.
Inheritance tax regulations vary from state to state. Most states divide beneficiaries into different classes based on their family relationship to the deceased (immediate, direct, and unrelated) and set exemptions and tax rates based on these categories.
Most states only tax an inheritance over a certain amount. They then calculate a percentage of that total; it can be flat or stepped.
For example, Kentucky charges a rate that ranges from 4% to 16% and increases with the inheritance amount from $1,000 to over $200,000. A flat dollar figure is also set, ranging from $30 to $28,670 based on the sum inherited.
What are the Inheritance Tax Rates and Thresholds?
The standard inheritance tax rate is 40%. It is only levied on the part of your estate that is above the threshold.
Most states have an inheritance tax on legacies above a certain amount. In some cases, the size of the estate is significant. For example:
If the estate is less than $25,000, then no tax is due when the estate passes to the beneficiaries.
• In Maryland, inheritance recipients of estates under $50,000 are also exempt.
When do you have to pay inheritance tax?
Inheritance tax must be paid by the end of the sixth month after the person’s death. If it is not paid by then, HMRC will start charging interest.
The executors can collect the tax on certain assets, such as B. real estate, in installments over ten years. However, interest will still be charged on the outstanding tax amount.
If the asset is sold before all IHT is paid, the executors must ensure that all installments (and interest) are paid at that time.
How to avoid inheritance tax
While there are many exceptions and exemptions to estate taxes, particularly for spouses and children, residents of significant wealth in a state with a may still want to minimize the burden on heirs.
A common strategy is to buy a life insurance policy for the amount you want to bequeath and make the person you want to bequeath the beneficiary of the policy. The death benefit from an insurance policy is not subject to inheritance tax.
You can also invest assets in a trust—preferably an irrevocable trust. This effectively removes them from your estate and their classification as an heir upon your death.
When you set up the trust, you can set a schedule for distributing the funds.
Also see, How to Apply for Tax Exemption.
How much can you inherit without paying taxes?
The six US states with inheritance taxes provide different exemptions based on the size of the inheritance and the family relationship of the heir to the deceased.
The federal property tax exemption protects $12.06 million from taxes beginning in 2022. There is no income tax on inheritance.
What is the Federal Inheritance Tax Rate?
There is no federal estate tax, that is, a tax on the sum of assets received by a person from a deceased person. However, a state estate tax applies to estates greater than $11.7 million for 2021 and $12.06 million in 2022.
The tax is levied only on the part of the estate that exceeds these amounts. The rate is graduated, from 18% to 40%.
See also, What Does It Mean to Withhold Tax?
Do beneficiaries have to pay inheritance tax?
This depends on the family relationship with the deceased and the state in which the deceased lived or owned property. Only estates or real estate located in one of the six states that levy estate taxes can be subject to them.
Surviving spouses are generally exempt from inheritance tax. Other immediate relatives, such as the deceased’s parents, children, and siblings, are exempt from tax to varying degrees depending on the state.
You may be entitled to inherit a certain sum tax-free and pay a lower tax rate on the remainder.
Inheritance taxes primarily affect more distant relatives and unrelated heirs.
When someone dies and there is no living spouse, survivors receive the estate through inheritance. This is usually a cash endowment given to children or grandchildren, but an inheritance may also include assets like stocks and real estate.
The basis of property inherited from a decedent is generally one of the following: The fair market value (FMV) of the property on the date of the decedent’s death
There is normally no IHT to pay if you pass on a home, move out and live in another property for seven years. You need to pay the market rent and your share of the bills if you want to carry on living in it, otherwise, you will be treated as the beneficial owner and it will remain as part of your estate.
- Make a will.
- Make sure you keep below the inheritance tax threshold
- Give your assets away
- Put assets into a trust.
- Put assets into a trust and still get the income.
- Take out life insurance.
- Make gifts out of excess income.
- Give away assets that are free from Capital Gains Tax.
Knowing how inheritance taxes work will do you great good as it can significantly reduce your tax burden. However, it only affects residents in six states. And they apply mainly to distant relatives or those unrelated to the deceased.