When You Inherit Unexpectedly

surprised

Q. When my sister-in-law, Erin, got her 23 and Me results in the mail a couple years ago, she was surprised to find out that she is Scottish, Irish, German, and almost a quarter Native American. Since then, she has connected with relatives all over the world and locally, including a wealthy great uncle in McLean, who was adopted and was overjoyed to find family so close when he thought he had none.

When her great uncle died last month, Erin found out that he left her his home and money from his investments. This was completely unexpected and she wasn’t sure how to proceed. I told her that you write an “Ask the Expert” newsletter and that I would ask. So, here’s her question: “(w)hat actions should you take to avoid unexpected taxes or expenses when you are left an inheritance that you didn’t expect?” Thanks for your help!

A. Whether due to the untimely death of a loved one, or because you were a named beneficiary and didn’t know it, the unplanned event may prompt uncertainty about how to handle the assets.

Since your sister-in-law seems to be inheriting a sizeable amount, she will need to take steps to avoid making a mistake that could result in unexpected taxes or expenses. Right now, she shouldn’t rush into anything without heeding the advice of an experienced estate planning attorney and financial planner, such as myself. She should also be thoughtful about who she tells about her inheritance and avoid sharing the information with too many people. This way, she won’t be inundated with people showing up wanting loans or gifts.

Are Assets Taxable When They Pass to Beneficiaries?

The good news is that, in most cases, assets pass to beneficiaries without the transfer of ownership becoming a taxable event. Here are some things to know about estate and inheritance taxes:

Federal Estate Taxes are Rarely Owed: Federal legislation passed in 2017 doubled the amount that an individual can give away (during live and/or upon death) without it being subject to the 40% federal estate and gift tax. That lifetime exemption is currently $11.58 million for 2020 (it adjusts yearly for inflation, and after 2025 it is scheduled to revert back to the previous amount, which was $5 million, and will be higher with adjustments for inflation). There aren’t very many people who have estates over that amount, so it’s rare to see a federal estate tax situation. But, it’s important to understand that if estate taxes are owed, the recipients do not pay those taxes. It is always the estate of the giver that pays the estate taxes.

State Estate Tax

D.C.’s estate tax exemption is $5,762,400 for 2020, and is being reduced to $4 million per individual starting in 2021.

Maryland’s estate tax exemption is $5 million for 2020 and beyond.

Virginia has no estate tax.

Taxes may be owed on investment income and appreciation: When you receive a gift or an inheritance, and you invest it, you will owe income tax on the interest and dividends received as a result of your investment. Likewise, when you sell an inherited asset — such as a house or stocks — you may owe taxes on any appreciation between its market value when the person died (called the “stepped-up basis”) and the price for which you sell it. If you are gifted an asset, you take over the giver’s tax basis, so if you later sell the asset, you may wind up paying a much higher capital gains tax than if you were to inherit the asset upon death.

Inheritance taxes in VA, DC, or Maryland: While estate taxes are paid by the estate of the deceased, inheritance taxes are taxable to the recipient of the bequest. Luckily, there are NO inheritance taxes in Virginia, or DC. Maryland does have an inheritance tax — 0.9% on the value of property passing to a child or other lineal descendant, spouse, parent or grandparent; 8% on property passing to siblings; 10% on property passing to other individuals.

Seek assistance if the inheritance involves a trust: If the inheritance involves a trust, experts all agree you should enlist the help of an attorney to avoid snags.

When you Inherit a Home

When a home gets passed on after the death of a relative, there are three options that beneficiaries typically choose from: live in it, rent it, or sell it.

If there’s a mortgage on the house, that debt also comes with the home. This means the beneficiary is responsible for paying that obligation.

Selling an inherited housewhen someone in her house and then later sells it, whether immediately or years in the future — any capital gains that might be taxable are based on the fair-market value at the time of the owner’s death, as mentioned above, and not the original purchase price. For instance, in this scenario asked about a bar, if her great uncle paid $100,000 for the house in 1980 and its fair-market value at his death in 2020 is $1,000,000, only the difference between that date of death value and the sale price would be considered a capital gain, which may be taxable.

Depending on how she uses the house and her tax bracket, rates on long-term gains range from 0% for lower-income taxpayers, to 15% or 20% for those with higher incomes.
If she chooses to live in the house for at least two years in a five-year period, and then sell it, she gets to exclude a certain amount of appreciation from capital gains taxation because it qualifies as a primary residence, which is $250,000 for individual taxpayers and $500,000 for married couples filing jointly.
If she doesn’t want to sell the home and has no interest in living in it, renting it out can be an option for some sudden homeowners, similar to your sister-in-law.
And, if she doesn’t want to deal with the property at all, she doesn’t have to accept it. Disclaiming an inherited asset involves formally alerting, in writing, the estate’s executor, trustee, or custodian that you don’t want it. She must generally do this within nine months of the owner’s death, and it cannot be reversed. She should consult an attorney to find out if there are any local requirements for disclaiming property. Please see my article, “When the Inheritance You Left Isn’t Wanted” for more details.

When You Inherit Retirement Accounts

Since your sister-in-law is not the decedent’s spouse and is inheriting retirement assets (i.e., from an individual retirement account, a 401(k), or similar workplace plan), she would set up an inherited IRA and have the money transferred.

She has a limited time to empty the account. Under the Secure Act, which was signed into law last year, retirement assets must generally be distributed fully within 10 years after the retirement account owner died.

There are exceptions to this, including for spouses, who can still roll over out the inherited funds into the spouse’s own IRA.
Other exceptions include minor children, disabled individuals, or those who are less than 10 years younger than the decedent.

If the account she inherits is a Roth IRA, she should be aware that the account must have been open at least five years prior to the owner’s death or she’ll face taxes on any earnings she withdraws. Otherwise, all Roth distributions are tax-free. She still would need to empty the account within 10 years if she doesn’t meet an exclusion. However, since the distributions from a Roth account are tax free, she can let the Roth account grow and then take the entire distribution in year 10 with no tax consequences.

Spouses have more options, depending on the person’s circumstances and the decedent’s age. For this reason, it makes sense to consult with an experienced attorney and financial advisor, such as myself, to ensure that you don’t inadvertently set yourself up for a mistake.

Seek Professional Advice if You Are Left an Inheritance

There are many different options if you find yourself with a sizeable inheritance. However, before you rush into something you later regret, stop and take stock of how it’s going to affect your balance sheet.

A good way to sort out a plan is to think about where you see yourself in one, two, or even three decades time. Where would you like to be living? Will you be retired? Are you going to settle in one place or would you like to see more of the world? Do you want to be working? Answering these and other questions will give you some goals to aim for and also allow your financial advisor to create a comprehensive financial plan more effectively.

At this stage, your sister-in-law should seriously consider working with an expert.  An advisor will be able to make recommendations based on her circumstances and her financial goals.

Make Sure Your Estate Planning Documents Are Always Up-to-Date

If you (and/or your sister-in-law) have already had your estate planning documents completed by our firm, call us and be sure to ask about the Farr Law Firm’s Lifetime Protection Program®, which ensures that your documents are properly reviewed and updated as needed, so that they will always have the proper effect under the law.

If you or members of your family have not done Incapacity Planning or Estate Planning, or if a loved one needs nursing home care or even if your loved one is already in a nursing home, please contact us as soon as possible to make an appointment for a no-cost initial consultation:

Estate Planning Fairfax: 703-691-1888
Estate Planning Fredericksburg: 540-479-1435
Estate Planning Rockville: 301-519-8041
Estate Planning DC: 202-587-2797

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