If the note you inherited came from an installment sale, the gain the person who died had not yet reported generally passes to you as income in respect of a decedent, and the note does not get the usual step-up in basis at death. You report that gain as you collect, or largely all at once if you sell. This is general information, not tax advice, so speak to a CPA or tax adviser before you collect, sell or split the note.
Most heirs expect inherited property to come with a fresh tax start. A house or a stock portfolio usually does: its basis is reset to its value on the date of death, so little or no gain is left to tax. An installment note is one of the main exceptions, and it surprises people at exactly the moment they are deciding whether to keep or sell.
The terms you will hear
- Basis. Roughly, the part of an asset’s value that has already been taxed or that represents its cost. Gain is what you receive above basis.
- Step-up in basis. The general rule, in IRC 1014, that inherited property takes a basis equal to its value at death.
- Income in respect of a decedent (IRD). Income the person who died had earned or was entitled to but had not yet reported. It is covered by IRC 691, and IRC 1014(c) says the step-up does not apply to it.
- Installment obligation. A note taken in payment when property was sold on terms, with the gain reported as payments arrive. See what happens to the installment-sale deferral when a note is sold.
Why an installment note keeps its old basis
When the original owner sold the property and took a note, they were reporting the profit a little at a time as principal came in. At their death, part of that profit was still unreported. Tax law treats that unreported profit as income the decedent had already earned, so it is IRD, and it carries over to whoever receives the note.
Under IRC 691(a)(4), the heir generally reports the payments the same way the decedent would have: the same share of each principal payment counts as gain, at the same gross profit percentage. Interest is reported separately. Interest that had built up before the death is part of the IRD; interest that accrues afterward is ordinary income to the heir in the usual way. Notes issued or bought below their face amount can also bring in the market discount and OID rules.
Passing the note at death is not itself treated as a sale. IRC 453B, which normally triggers the deferred gain when a note changes hands, has an exception for transfers at death. So the estate does not owe income tax on the gain just because the holder died. The deferred gain simply moves to the next holder.
A worked example
Illustrative example. The figures for your note and the estate will differ.
A mother sold a parcel of land years ago and carried a note. Her profit was 60% of the price, so 60 cents of every dollar of principal she collected was gain and 40 cents was her cost coming back. She dies with $100,000 still owed on the note, which passes to her son.
| Figure | If he assumes a step-up | What generally applies |
|---|---|---|
| Balance at death | $100,000 | $100,000 |
| His basis in the note | $100,000 | $40,000 |
| Gain if he collects every payment | $0 | $60,000, over the years |
| Gain if he sells for $85,000 | $15,000 loss | $45,000, in one year |
The gap between those columns is why heirs are caught out. Someone who believes the note was stepped up expects a sale below the balance to produce a loss. In fact it produces a sizable gain, all in the year of the sale, on top of interest income.
What happens if you sell the inherited note
Selling or otherwise transferring the right to the payments generally brings the IRD into income at that point. In broad terms, the gain is the price you receive minus the basis carried over from the decedent. In the example, a sale at $85,000 against a $40,000 basis gives $45,000 of gain in one tax year.
A few related events can have the same effect:
- Forgiving the note. If a will cancels the debt, or the heirs agree to forgive it, the cancellation can be treated as a transfer that triggers the IRD.
- The borrower is also an heir. If the note passes to the person who owes it, the debt and the right to collect it meet in one person, and the rules treat that as a cancellation.
- The estate sells before distributing. If the executor sells the note, the estate reports the gain rather than the heirs. Whether that is better depends on the estate’s tax position and when the money is distributed. See selling a note as executor.
The estate tax side
Income tax and estate tax are separate. For estate tax purposes the note is generally valued at its fair market value at death, which for a private note is often below the balance. A note appraisal is the usual way to support that figure.
Where federal estate tax was actually paid, IRC 691(c) generally allows the heir who reports the IRD an income tax deduction for the estate tax attributable to it, so the same dollars are not taxed twice in full. Most estates owe no federal estate tax, so this deduction often does not apply. Some states have their own estate or inheritance tax.
Notes that did not come from an installment sale
Not every inherited note works this way. If the decedent lent cash, bought the note from someone else, or elected out of the installment method and reported the whole gain in the year of the original sale, there may be little or no deferred gain inside the principal. Accrued interest at death is still IRD, but the principal may be treated quite differently. The first job is to find out how the note was created and how the original sale was reported. The decedent’s returns, especially any Form 6252, Installment Sale Income, will usually answer it.
How the tax affects the keep-or-sell decision
- Keeping the note spreads the gain over the remaining payments, the same way the decedent was spreading it. It also leaves you collecting, checking taxes and insurance, and carrying the risk of default.
- Selling the note brings the gain into one year, reduced by the discount on the price. It ends the collecting and the risk, and gives cash that is easier to divide among several heirs. See how several heirs split a note.
- Selling part of the payments through a partial purchase changes the amount and timing again. How a partial is taxed depends on how it is structured, so ask before relying on it.
None of these is right for every family. Compare what each heir would keep after tax under each option, and include the option of keeping the note. If you need a real price to run those numbers, ask for a free quote; every offer shows the balance, the buyer’s yield and the discount, and there is no obligation to sell.
What to gather for your adviser
- The decedent’s return for the year the property was sold, with any Form 6252
- Their most recent return, and the final return if it has been prepared
- The note, the recorded mortgage or deed of trust and the original closing statement
- A payment record showing principal and interest received before and after the death
- The balance at the date of death and any appraisal used for the estate
- Letters testamentary or other proof of who can act for the estate
If you are still working out what you have inherited, start with what to do when you inherit a mortgage note, then come back to the tax questions once the papers are in hand.
Related questions
Do I get a stepped-up basis on an inherited note?
Generally not, if the note came from an installment sale. The unreported gain is income in respect of a decedent, and IRC 1014(c) excludes it from the step-up. Notes from other sources can be treated differently, so check how the note was created.
Does the estate owe income tax when the holder dies?
Passing a note at death is generally not treated as a sale under IRC 453B, so the death itself does not trigger the gain. The deferred gain moves to whoever receives the note.
If I sell the inherited note, when is the gain taxed?
Generally in the year of the sale. The gain is roughly the price minus the basis carried over from the decedent. Talk to your tax adviser before you agree a closing date.
What if the will forgives the borrower's debt?
Cancelling the note can be treated as a transfer that brings the deferred gain into income, even though no cash changes hands. Get advice before the estate acts on it.