There was a time when federal estate taxes significantly impacted a high-net-worth individual’s ability to pass assets on to their heirs. However, in 2022, the current exclusion of $12.06 million for individuals and $24.12 million for married couples has turned this into a non-issue for many Americans.
It’s important to note, though, that you may not be completely in the clear. If you live in one of the states that currently impose an inheritance tax, you’ll want to address this as part of your financial plan.
What is an Inheritance Tax?
The terms estate tax and inheritance tax are often used interchangeably, but they are not the same. While an estate tax is deducted from a deceased person’s estate after debts have been paid, an inheritance tax is paid by the beneficiary who inherits the estate.
Which States Impose Inheritance Taxes?
There are currently six states that levy an inheritance tax:
- Iowa – up to 15%
- Kentucky – up to 16%
- Maryland – up to 10%
- Nebraska – up to 18%
- New Jersey – up to 16%
- Pennsylvania – up to 15%
Each state varies the amount of tax owed depending on the beneficiary’s relationship to the deceased. Following is a brief overview of the state-specific laws.
Iowa
On May 19th, 2021, the Iowa state legislature passed S.F.619, a law that will phase out inheritance taxes at a rate of 20% per year. This will continue each year until it is completely eliminated on January 1st, 2025.
Kentucky
In Kentucky, the amount of inheritance tax owed depends on the class assigned to the beneficiary. Class A beneficiaries, including the surviving spouse, parents, children, grandchildren, siblings, and half-siblings, are exempt from inheritance taxes.
Class B beneficiaries include nieces and nephews, half-nieces and half-nephews, aunts, uncles, great-grandchildren, daughters-in-law, and sons-in-law. All other beneficiaries, including cousins, fall into the Class C category. Class B and C beneficiaries are both taxed at a rate of 4% to 16% and receive a $1,000 and $500 exemption, respectively.
Maryland
In Maryland, inheritance taxes are only imposed on “collateral heirs.” This includes nieces, nephews, and friends. Close relatives are exempt from Maryland state inheritance taxes.
Nebraska
In Nebraska, surviving spouses are exempt from inheritance taxes, and charitable organizations are usually exempt as well. “Immediate relatives” pay a 1% tax on inheritances over $40,000. This includes parents, grandparents, siblings, children, grandchildren, and other lineal descendants and their spouses. “Remote relatives” and other beneficiaries pay a 13% tax on inheritances over $15,000.
New Jersey
In New Jersey, Class A beneficiaries include the deceased’s spouse or domestic partner and lineal decedents. These beneficiaries are exempt from inheritance tax.
Class C includes siblings, spouses of children, and surviving spouses of children. These beneficiaries receive a $25,000 exemption and are taxed at rates starting at 11% for the first $1,075,000 and increasing from there. Class D consists of all other recipients except charities and governments. These beneficiaries are taxed at a rate of 15% on the first $700,000 and 16% for inheritances above this amount.
Pennsylvania
In Pennsylvania, surviving spouses and charitable organizations are exempt from paying inheritance taxes. If the deceased is age 21 or younger, parents, adoptive parents, or stepparents are also exempt.
When the deceased is over 21, close family members pay a 4.5% inheritance tax, with the exception of siblings and half-siblings, who pay 12%. Friends and distant family members, including nieces and nephews, aunts and uncles, and cousins, are taxed at a rate of 15%.
What about California?
Good news for California residents: California is not among those states who impose a state inheritance tax. However, California residents who inherit assets from a deceased friend or loved one may still be liable for federal estate taxes.
California residents can take advantage of the $12.06/$24.12 million estate tax exclusion discussed in our opening paragraph
Only people who inherit an estate over this amount will potentially be obligated to pay federal estate taxes.
What if You Decide to Sell an Inherited Property?
Keep in mind that capital gains taxes (not estate taxes) may be due when you sell a property that you have inherited from close relatives.
For example, when you inherit a home from your parents that is worth substantially more than the value at which your parents purchased it, you will not be required to pay a tax on the total difference in value. When heirs receive inherited properties, past capital gains are forgiven, and the property is transferred to heirs at the current market value at time of passing. This is referred to as receiving property with a “step-up in basis” and can be a very powerful way for parents to transfer wealth to their heirs free of capital gains taxes.
If heirs then hold onto the property and sell it a later date, they will only be liable for appreciated capital gains that occurred during their holding period.
Suppose your parents paid $50,000 for the house in 1970. Your parents passed away six years ago, and the house was valued at $500,000 when you inherited it. Today, the house is valued at $750,000. If you sold the house today, you would potentially be liable to pay capital gains tax on $250,000 – or the difference between the property’s value at time of inheritance and the value when you sold it.
The Bottom Line
If you live in a state with inheritance taxes, it’s important to address this as part of your overall financial strategy. Starting this process as early as possible will give you more opportunities to find ways to potentially reduce your beneficiary’s financial liability.
For more information on tax deferral strategies and for referrals to real estate tax advisors, please contact us at info@FGG1031.com or at 408 392-8822.
- https://www.aarp.org/money/taxes/info-2020/states-with-estate-inheritance-taxes.html
- https://iowafirm.com/blog/2021/Jun/changes-coming-to-inheritance-tax-in-iowa.html#:~:text=If%20one%20were%20to%20die,80%25%20from%20the%20original%20rates.
- https://revenue.ky.gov/Documents/92F101714.pdf
- https://fredfranke.com/practice-areas/estate-trust-administration/maryland-estate-and-inheritance-taxes/#:~:text=Maryland%20is%20one%20of%20a,a%20niece%2C%20nephew%20or%20friend.
- https://www.nolo.com/legal-encyclopedia/nebraska-inheritance-tax.html#:~:text=Close%20relatives%20pay%201%25%20tax,amount%20over%20the%20first%20%2440%2C000.
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