Does a Beneficiary Pay Taxes on an Inherited House?

house with coin stacks concept

A house can be a significant inheritance. However, there are also legal and financial responsibilities that come with it. One of the first things you, as a beneficiary, might be wondering is whether you are required to pay tax on the property you inherited. Whether you’re planning on moving into the property, renting it out, or selling it, it’s critical to understand your tax obligations under Pennsylvania and federal law.

Understanding the Pennsylvania Inheritance Tax

Although Pennsylvania does not have an estate tax, there is an inheritance tax. These two types of taxes should not be confused. Unlike an estate tax which is charged on the value of a decedent’s estate after their death but before distribution to the heirs, an inheritance tax is essentially a transfer tax. It is imposed on the property received by the beneficiary, and it is their responsibility to pay it.

The amount of inheritance tax a beneficiary is required to pay on the property they receive depends upon their relationship to the decedent. The inheritance tax rates in the Commonwealth are as follows:

  • Direct descendants — Lineal heirs, such as children and grandchildren, are subject to a 4.5% tax rate on inherited property.
  • Siblings — Siblings who share at least one parent in common with the decedent, either by blood or through adoption, are taxed at a rate of 12%.
  • Other heirs — A 15% tax rate applies to nieces, nephews, in-laws, friends, and other beneficiaries.
  • Children under 21 — There is no inheritance tax imposed on transfers made to the decedent’s children if they are 21 or younger.
  • The decedent's spouse — A surviving spouse who owned property jointly with the decedent is exempt from the inheritance tax.
  • Charitable organizations — Charitable organizations and government entities are exempt from paying the inheritance tax.

The inheritance tax is levied regardless of whether the decedent died intestate or the assets have been transferred through a last will and testament, a trust, or a payable-on-death account.

Is Any Real Estate Exempt from the Inheritance Tax?

The Pennsylvania inheritance tax applies to most house transfers. However, there are two special exemptions that have been carved out by the Pennsylvania legislature that are crucial to note. Inherited farmland is excluded from the tax, provided it has been passed to family members and continues to be used for agricultural purposes for at least seven years. In addition, the farm must produce $2,000 or more a year in gross income to qualify as exempt.

There is also an exclusion for small family businesses with fewer than 50 employees and less than $5 million in assets. If the business is inherited by a family member and has existed for five years or more — and will continue operating for at least seven years — the inheritance tax is not applicable.

Can a Beneficiary Minimize the Impact of the Pennsylvania Inheritance Tax?

There are a few ways a testator may be able to minimize the impact the inheritance tax can have on their loved ones. A common method to avoid the tax is by gifting — Pennsylvania does not tax transfers made as gifts twelve months or more before the decedent’s passing. But when utilizing this strategy, it’s important to be aware that federal gift tax laws and the Medicaid look-back period still apply.

Since life insurance is not subject to the Pennsylvania inheritance tax, it can be used to bequeath assets to beneficiaries who would otherwise be taxed at higher rates. For instance, it might make sense to leave life insurance proceeds to a niece or nephew who is taxed at 15%, rather than real estate. Non-life insurance assets can also be converted into life insurance to lessen the inheritance tax consequences.

While the inheritance tax is required to be paid within nine months of the decedent’s passing, Pennsylvania law allows a five percent discount if it is paid within three months. Depending on the amount of the inheritance, this can result in considerable savings for a beneficiary.

Do You Have to Pay Capital Gains Taxes if You Sell Inherited Property?

Under federal tax law, there is a home sale tax exclusion for those who sell their primary residences. In such cases, a gain of up to $250,000 ($500,000 for couples) can be excluded from income. The law doesn’t apply if a beneficiary wishes to sell the house immediately upon inheriting it — but they may be able to take advantage of the rule if they decide to live in the house for two of the previous five years before putting it on the market.

Additionally, those who sell inherited property can benefit from the “step-up in basis” tax rules. Instead of basing the value of the home on the amount the original owner paid, the fair market value is assessed at the time of their passing. A beneficiary would only pay capital gains taxes on the difference between the price at which the property is sold and the stepped-up basis. This can substantially reduce the potential amount of capital gains tax owed by the beneficiary.

Contact an Experienced Pennsylvania Estate Planning Attorney

No one wants to think about the inevitable, but by planning ahead, you can have peace of mind that your wishes will be carried out in the future. Berman & Associates works with clients to create comprehensive estate plans that ensure their affairs are in order — and the tax consequences for their loved ones are minimized. Located in Media, Pennsylvania, we serve clients in Delaware, Chester, and Montgomery Counties, as well as in the City of Philadelphia. Contact us today to schedule a consultation.

Categories: Estate Planning