Real estate is one of the most common types of assets that pass from one generation to the next through inheritance. Whether you expect to inherit property or plan to leave some behind, it pays to be aware of the basic tax implications.
Fortunately, the vast majority of people who inherit real estate don’t end up paying any taxes on the property whatsoever. There are, however, some cases where estate or inheritance taxes could be assessed on inherited real estate. Here’s a rundown of how estate taxes work in the United States and what it means to you if you inherit or are given real estate assets.
Estate tax terminology
First, there are three different terms you might hear -- estate tax, gift tax, and inheritance tax -- and it’s important to know the difference.
An estate tax is a tax applied on property transfers at death. A gift tax is a tax levied on property transfers while both parties are alive. In the United States, the estate tax and gift tax are one unified concept. We’ll get to how taxable gifts are treated, but for the time being, just know that when you hear the terms “estate tax” and “gift tax,” they are actually referring to the same unified system.
An inheritance tax is a different concept. While estate tax is assessed to the estate of the person giving a gift or leaving assets to heirs, an inheritance tax is assessed on the person who inherits the assets. There is no estate tax on the federal level, but a few states have an inheritance tax that you may have to pay. We’ll get deeper into state estate and inheritance taxes later.
How the U.S. estate tax works
On the surface, the U.S. estate tax system looks quite complicated. There are 12 different estate tax brackets with rates ranging from 18% to 40%. Taxable estates ranging from $0 to $10,000 are taxed at an 18% rate, and on the higher end, the amount of taxable assets that exceeds $1 million is taxed at a 40% rate.
For real estate purposes, it’s also important to note that this includes money and property. As a simplified example, if someone leaves $10 million in cash and $5 million worth of real estate to heirs, it would be considered a $15 million estate. Real estate is valued based on the fair market value at the time of the decedent’s death.
Only wealthy households pay the estate tax
The estate tax may sound complex and expensive, but it’s important to realize that it only applies to wealthy households. Most Americans don’t have to worry about it. Specifically, all Americans are allowed to exclude a certain amount of assets from their taxable estate, known as the lifetime exemption. This amount is adjusted for inflation over time and is $11.58 million per person for 2020.
Note that this is a per person figure. Married couples can exclude twice this amount, or $23.16 million. If your spouse dies before you do and leaves you their assets, you can use both exemptions when leaving your estate to your heirs.
Technically, this is structured as a tax credit. Estate tax is calculated on all of your assets when you die, and there’s a nonrefundable credit equal to the tax that would be charged on the lifetime exemption ($4,577,800 in 2020).
This may sound complicated, but the end result is actually quite simple: Any assets left to your heirs will be taxed at a 0% rate up to $11.58 million and at a 40% rate beyond that amount. In other words, if you die with $20 million in assets that you leave to heirs, your calculated estate tax would be 40% of the $8.42 million that is in excess of your lifetime exclusion, or $3,368,000.
It’s also important to point out that estate taxes aren’t paid by people who inherit the property. Rather, any estate taxes due are paid directly by the estate before it is distributed to heirs. And if there aren’t enough liquid assets to pay the estate taxes due, property can be sold to pay the estate’s tax bill.
What about gifts?
Since the estate and gift taxes in the U.S. are part of a unified system, it’s important to address how gifts are treated by the IRS.
For starters, there is an annual exclusion amount that exempts many gifts from any potential taxation. In 2020, this amount is $15,000 per donor, per recipient. In other words, you can give $15,000 to as many people as you want in 2020 -- the IRS can’t touch one penny.
Any gifts you give beyond the annual exemption amount count toward your lifetime exclusion. Let’s say you give $50,000 to a loved one to help them buy a home. Of this amount, $15,000 would be excluded from any potential taxation thanks to the annual gift tax exemption. However, the other $35,000 would be reportable as a taxable gift, requiring that you file a gift tax return with the IRS.
Now, just because money (or assets) is reported as a taxable gift doesn’t mean you’ll need to pay tax on them. However, they do accumulate from year to year and count toward your lifetime exclusion.
In other words, if you die in 2020, your lifetime exclusion will be $11.58 million for estate tax purposes. If you’ve given a total of $3 million in taxable gifts during your lifetime, you’ll only be able to exclude $8.58 million of your assets from estate taxation.
The only time you would have to pay any gift taxes while you’re alive is if you use up your entire lifetime exemption. If you have given away $11 million prior to 2020 and you give away another $1 million, it would trigger a taxable gift to the extent that your new gift pushes you over $11.58 million.
Furthermore, there are a few special rules to know:
- You can give any amount to your spouse in most cases, without regard to the gift or estate tax.
- Any amount given to charity is free of gift tax and doesn’t count toward your lifetime exemption.
- Higher education expenses are free of gift and estate tax consequences if and only if the payment is made directly to the school.
- Medical expense payments are free of gift and estate tax consequences if and only if the payment is made directly to the hospital or medical service provider.
Don’t forget about state taxes
Not having to pay federal estate tax doesn’t mean you won’t have to pay anything to your state. Some states have their own estate and/or inheritance taxes that you might need to worry about.
As mentioned, estate taxes are paid directly by the decedent’s estate. On the other hand, inheritance taxes are paid by the person inheriting money or property. Only one state (Maryland) has both an estate and inheritance tax, meaning that money left to heirs can effectively be taxed twice.
Estate tax rates can be as much as 20% on the state level, while inheritance tax rates can be as much as 16% in the case of large inheritances. Some of the states that have these taxes use the same lifetime exemption amount the IRS does, while some have significantly lower thresholds where the estate or inheritance tax kicks in.
States that have an estate tax:
- New York
- Rhode Island
- Washington (state)
States that have an inheritance tax:
- New Jersey
State that has both estate and inheritance tax
So, will you (or your heirs) have to pay estate tax on inherited real estate?
The short answer is “maybe.” The bottom line is that there are very few situations when you would personally have to pay tax on inherited real estate. With that in mind, here’s a rundown of the key points you need to know if you inherit properties or land assets in 2020:
- If the person who left you the property had a total estate worth more than $11.58 million ($23.16 million if a married couple) when combined with any taxable gifts made during their lifetime, their estate will likely have to pay estate tax.
- If a taxable estate doesn’t have enough liquid assets to pay any estate tax due, it’s possible that real estate could be sold in order to pay the tax. In other words, the IRS won’t accept property. This can get a bit complicated, but estate taxes are generally due nine months after the date of death, so asset sales can be necessary. Typically, selling real estate is only considered after other options (selling stock, using life insurance proceeds, etc.) are exhausted.
- If you live in a state with an estate tax, their estate may have to pay estate tax, even if their estate isn’t in excess of the federal limit.
- If you live in one of the six states that have an inheritance tax (see list above), you may have to pay inheritance tax.
- If your state doesn’t have an inheritance tax, you won’t pay a dime of tax on inherited property.
Estate tax can be a complex issue, especially in the case of large estates with a lack of liquid assets, so it’s important to seek the advice of a qualified estate planning attorney in these types of situations. But in most scenarios, beneficiaries inheriting property will find the tax laws on this issue quite favorable.