By Anthony Diosdi
Many U.S. income tax questions arise in connection with receipt of inherited property. These questions generally include whether the recipient must include the value of such property in gross income for U.S. income tax purposes and what will be the U.S. income tax consequences of the recipient’s subsequent disposition of the inherited property. This article will briefly summarize the more relevant U.S. income tax consequences in connection with inherited property with emphasis on property inherited from a foreign individual. Anyone reading this article must be aware that the U.S. also has a transfer tax regime that could impose an estate tax upon the transfer of property of a decedent. However, the estate tax is generally imposed on the estate of a decedent and not on the recipient.
As a general rule, gross income (for the purposes of calculating an income tax liability) does not include the value of property by bequest, devise, or inheritance of the status of a decedent for U.S. tax purposes. Thus, in general, an individual does not have to include the value of inherited property in his gross income. This general rule, however, does not apply to the income generated by inherited property or where the bequest, devise, of inheritance is of income from property. Therefore, before an individual who receives an inheritance can determine the U.S. income tax consequences of such inheritance, he or she must adequately characterize the inheritance as property or income from property. For example, following a tax analogy, the inheritance of a tree would not subject the recipient to income tax while the inheritance of the fruits from the tree would be subject to U.S. income tax.
An additional benefit of inherited property is what is commonly referred to as the “step-up” in the basis of property. The determination of basis (or adjusted basis) of property is necessary primarily for determining gain or loss on the sale or other disposition of such property and for calculating depreciation, amortization, or other cost recovery deductions with respect to such property. As a general rule, property acquired from a decedent has a basis in the hands of the recipient equal to its fair market value as of the decedent’s date of death, or if elected, the alternative valuation date (6 months from the date of death). For example, if the decedent owned property with a fair market value of $500,000 on the date of death and the decedent’s basis in such property was $100,000, the decedent would have realized a gain of $400,000 (for income tax purposes) had he sold such property immediately before death. However, because of the step-up in basis rules, the individual receiving such property from the decedent could sell such property for its fair market value immediately after the date of death without realizing any gain ($500,000 – $500,000 =$0). Remember, this article does not address the potential transfer tax liability and depending upon the U.S. or foreign status of the decedent, the situs of the inherited property, the value of the inherited property, and numerous other potentially relevant rules, U.S. estate tax may or may not be due.
The step-up rules, however, may not always apply in the case of property passing from a foreign individual or when the property consists of certain specially defined non-U.S. corporations. Under certain circumstances, the property passing from a decedent may retain its “original” basis in the hands of the decedent and may cause substantial U.S. income tax consequences to the recipient upon a subsequent disposition of such property. For instance, inherited foreign stocks classified as Passive Foreign Investment (“PFIC”) shares are not entitled to a step-up basis. In addition, property acquired from a decedent by a certain form of ownership (e.g., a joint tenancy with right of survivorship) may not receive a step-up in basis unless such property is included in the decedent’s U.S. gross estate for estate tax purposes.
Thus, any foreign individual wishing to provide his or her eventual beneficiaries with maximum U.S. income tax benefits should carefully review (and revise if necessary) with competent U.S. tax counsel his or her estate planning documents and form of ownership of property regardless of whether or not such a foreign person would be subject to the U.S. estate tax.
Anthony Diosdi concentrates his practice on tax controversies and tax planning. Diosdi Ching & Liu, LLP represents clients in federal tax disputes and provides tax advice throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: Anthony Diosdi – firstname.lastname@example.org.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.