Understanding the Impact of Taxes on Inherited Assets in California

When inheriting assets in California, it’s important to understand the potential tax implications. Inherited property and assets can be subject to various taxes that can affect their value, how they are distributed, and whether heirs or beneficiaries need to take specific steps to mitigate these costs. California’s tax laws can be complex, and the tax treatment of inherited assets may differ depending on factors like the type of asset and its value.

This blog post outlines the key aspects of taxes on inherited assets in California and how beneficiaries can navigate the process more effectively.

California Inheritance and Estate Taxes

California is unique in that it does not impose a state inheritance tax. This means that, unlike some other states, California does not tax the assets beneficiaries receive directly from a deceased person’s estate. However, this does not mean that inherited assets are completely free of taxation.

Even though California does not have an inheritance tax, there are other tax considerations that beneficiaries need to be aware of, such as federal estate taxes, income taxes on inherited assets, and property taxes.

Federal Estate Taxes

While California does not have an estate tax, the federal government imposes estate taxes on estates that exceed a certain threshold. For 2024, the federal estate tax exemption is $12.92 million. This means that if the value of an estate exceeds this amount, it may be subject to federal estate tax. The federal estate tax rate can range from 18% to 40%, depending on the size of the estate.

For estates that do not exceed the exemption threshold, no federal estate taxes will be due. However, beneficiaries may still be subject to other forms of taxation depending on the type of asset they inherit.

Income Taxes on Inherited Assets

One of the most significant tax considerations for beneficiaries is income tax on inherited assets, particularly when inheriting stocks, bonds, or other investment assets. In general, inherited property receives a step-up in basis, meaning the value of the asset is adjusted to its fair market value on the date of the decedent’s death. This is important for determining the tax liability if the asset is later sold.

For example, if someone inherits stocks or real estate, and those assets have appreciated over time, the beneficiary will not be required to pay capital gains taxes on the appreciation that occurred during the decedent’s lifetime. Instead, the beneficiary’s cost basis is the market value on the date of death, meaning that the capital gains tax is only applicable to the appreciation that occurs after the date of inheritance.

However, if a beneficiary sells the asset for less than its stepped-up value, there may be a capital loss, which could reduce overall taxable income.

Property Taxes on Real Estate

When inheriting real estate in California, property taxes can be a significant concern. California’s property tax system is governed by Proposition 13, which limits property tax increases to a maximum of 2% per year. The base value for property tax purposes is set at the purchase price when the property is bought or transferred.

In the case of an inherited home, the property tax implications can vary depending on how the property is transferred. If the property is transferred to a child or spouse, for example, it may be eligible for Proposition 58, which allows for a property tax exemption or reduction in some cases. This means that the property taxes on the inherited home may be lower than they would be if the property were sold to a third party.

However, if the home is sold after inheritance, the buyer will be subject to the current market value of the property, which could result in a higher property tax rate.

Inherited IRAs and Retirement Accounts

Inherited retirement accounts, such as IRAs or 401(k)s, are subject to different tax rules. The tax treatment of these accounts depends on the type of account and the relationship of the beneficiary to the decedent. If the beneficiary is a spouse, they may have the option to treat the inherited IRA as their own and defer taxes until they begin making withdrawals.

For non-spouse beneficiaries, the rules are more complicated. The Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 eliminated the ability of most non-spouse beneficiaries to stretch distributions from inherited IRAs over their lifetime. Instead, non-spouse beneficiaries must now withdraw the entire balance within 10 years of inheritance. These distributions are subject to ordinary income tax, which can be significant depending on the size of the account and the tax bracket of the beneficiary.

Gift Taxes on Inherited Assets

In general, inherited property is not subject to gift taxes. Gift taxes are typically only applicable when an asset is given during the decedent’s lifetime. However, if assets are gifted during the probate process or after inheritance, gift tax rules may apply.

For instance, if a beneficiary receives a portion of the estate but later chooses to give it away as a gift, the recipient of the gift may be subject to gift taxes. The person making the gift (the donor) may be responsible for paying the tax if the value of the gift exceeds the annual gift tax exclusion amount, which is $17,000 per recipient in 2024.

Navigating the Tax Implications of Inherited Assets

Understanding the tax implications of inherited assets in California can be complicated. Each type of asset comes with its own set of rules and considerations. To avoid unexpected tax liabilities, it is critical for beneficiaries to take certain steps, such as:

• Consulting with a tax advisor: Beneficiaries should seek advice from a tax professional who can help them understand their specific tax obligations related to inherited assets. A tax advisor can also assist with strategies to minimize taxes, such as tax-loss harvesting or charitable giving.
• Reviewing the estate plan: If possible, beneficiaries should review the decedent’s estate plan to understand how assets are structured and whether any tax planning strategies, such as trusts, were put in place to reduce tax liabilities.
• Filing required documents: Beneficiaries may need to file tax returns or other documentation depending on the type and value of the assets inherited. An experienced probate lawyer can help ensure that the necessary filings are made in a timely manner.
• Selling or holding assets: Deciding whether to sell or hold onto inherited assets can have tax consequences. A qualified attorney or tax professional can help determine the best course of action based on the asset’s value, the beneficiary’s tax situation, and long-term financial goals.

Managing Taxes on Inherited Assets in California

While California does not impose an inheritance tax, the tax consequences of inheriting assets can still be significant. From federal estate taxes and income taxes to property taxes and rules for retirement accounts, beneficiaries should be aware of how taxes will affect the assets they inherit. Consulting with a probate lawyer and tax professional is crucial to ensure that inherited assets are managed in a way that minimizes tax liability and complies with California’s laws. By taking the right steps, beneficiaries can better navigate the complexities of inherited asset taxes and protect their financial interests in the process.