Taxes can be daunting. There are many different types of taxes in the United States and rules that go along with each one, making this subject very difficult to grasp. Receiving an inheritance can, thus, come with a lot of questions, one of the most common ones being whether it will result in inheritance tax.
You may be subject to an inheritance tax if you inherit money or property after a loved one passes away. Even though California is notorious for being one of the highest-taxed states in the nation regarding income taxes, not all states are subject to inheritance tax – California being one of them. Remember that this does not necessarily mean that collecting your inheritance will be completely tax-free.
Keep reading to learn everything you need to know about how the inheritance tax and estate tax work in the state of California for peace of mind.
An inheritance tax is a tax imposed by some states on the recipients of inherited assets. It’s a levy on assets inherited from a deceased person. The inheritance tax is not really common in the U.S, and the federal government doesn't have an inheritance tax. As of 2022, only six states have an inheritance tax in place.
Whether or not it applies depends on the state in which the deceased lived or owned property, the value of the inheritance, and the beneficiary's relationship to the decedent. For example, spouses are automatically exempt from inheritance taxes. At the same time, more distant heirs, such as siblings, nieces, nephews, and friends, typically pay inheritance tax, with the tax rate escalating as the degree of kinship decreases.
An estate tax is a financial levy on an estate that exceeds the minimum threshold set by law based on the current value of its assets. State and federal taxes and laws vary, but generally, only estates valued at or above specific amounts are subject to taxes on estates. For example, federal estate tax generally only applies to assets over $12.06 million in 2022.
Estate taxes are calculated based on the estate's fair market value (FMV) rather than what the deceased originally paid for its assets. The tax is levied by the state where the deceased person was living at the time of their death. Recipients of an estate's assets may be subject to inheritance tax if it’s also above certain limits. However, assets transferred to spouses are exempt from estate tax.
While inheritance tax and estate tax are both referred to as a “death tax,” and often used interchangeably, they are in fact two distinct taxes. The main difference between inheritance and estate taxes is the person responsible for paying the tax. Unlike an inheritance tax, estate taxes are charged against the estate regardless of who inherits the deceased's assets.
Inheritance tax is a levy on assets inherited from a deceased person. Unlike the estate tax, which is levied on the value of an estate, an inheritance tax is levied on the value of the inheritance received by the beneficiary, and it is the beneficiary who pays it. In other words, an estate tax is assessed on the estate before its assets are distributed, while an inheritance tax may be imposed on the bequest's beneficiaries.
Is there an inheritance tax in California? As of 2022, only six states collect inheritance tax - Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. Maryland has the dubious distinction of being the only state to collect both an estate and an inheritance tax as of 2022.
Luckily for all California residents and inherited property owners, inheritance is not subject to tax in California since 2005. So, if you live in California, you are inheritance tax-free as California does not have a state-level inheritance tax. However, there are a few exceptions to this rule, such as:
You’re probably wondering if the inheritance tax of another state applies to your inheritance. Even if you live in California or another state that does not have an inheritance tax, if the person you are set to inherit from was living in a state that does at the time of death, then you would owe an inheritance tax to that state.
For example, if you live in California and inherited assets from your cousin who lived in Kentucky at the time of death, you would owe the state of Kentucky inheritance tax because it’s one of the few states that still collect it. In contrast, if you would inherit from someone who passed away in California, you would be able to get the inheritance tax-free.
You’re probably relieved to learn that there are no federal or California inheritance taxes. However, California residents are still subject to the federal gift tax.
In 2022, federal gift tax allows individuals to leave up to $12.06 million in cash or assets to heirs during their lifetime (or $24.12 million for couples) without paying a gift tax. There are some ways for families to gift more than the IRS rule allows, such as using irrevocable trusts, marital deductions, and intrafamily loans.
Since it is not subject to inheritance tax, California does not require an inheritance tax waiver form. However, some states require the estate executor to submit an inheritance tax waiver when transferring stock ownership to an estate.
California does not impose an estate tax, but the federal government does. So, even though you won’t owe estate tax to the state of California, there is still the federal estate tax to consider. After someone passes away in the state of California, the only tax imposed on their assets will be a federal estate tax.
If you had property in another state that imposes a state-level estate tax, your estate could be required to pay both federal and state-level estate taxes. However, this applies only to estates worth over $12.06 million in 2022. If a California resident passes away with an estate valued less than the exemption amount, their estate will not be subject to federal estate taxes.
Married spouses can avoid paying a federal estate tax of up to $24.06 million after both have deceased if the proper legal processes are performed. Each spouse is entitled to their own federal estate tax exemption, although the rules for state-level estate taxes can vary.
If you’re the beneficiary of a trust, you must be wondering whether you need to pay taxes on a trust inheritance or not. The short answer? It depends on the source of the funds. Whether beneficiaries pay tax on monies received from a trust depends on how the distribution is classified.
If the money comes from the trust’s principal, you won’t be paying any taxes as principal trusts are not taxable to the beneficiary. However, you will owe income tax if the funds come from the trust's income (interest/earnings). The legal requirements of trusts can vary, so it’s best to consult with the trustee or legal and tax counsel for guidance.
Inheritance taxes can be minimized or even avoided in some cases, for example, by leaving assets via trusts or insurance policies, making charitable donations, or gifting sums during one's lifetime. Whether you live in an inheritance tax-free state like California or not, you can always avoid property taxes by ensuring you keep below the inheritance tax or estate tax thresholds with proper estate planning.
You can avoid paying capital gains taxes on an inherited property simply by selling it as soon as you inherit it, thus not leaving any room for the property to further appreciate in value. Another option is to turn the property into a rental or use it as a primary residence for at least two years. Of course, you can always opt to disclaim the inheritance entirely. However, keep in mind that the decision to disclaim is final and irreversible.
The good news for all Californians out there is that inheritance is generally tax-free in the state of California. However, that isn't to say you shouldn't pay attention to other taxes that may be involved when you inherit property or other assets, as there may be potential pitfalls to avoid.
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