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Avoiding Capital Gains Tax
When you inherit property, such as a house or stocks, the property is usually worth more than it was when the original owner purchased it. If you were to sell, there could be huge capital gains taxes, which could cost you thousands of dollars..
What Is Capital Gain?
Capital gain is the difference between the “basis” in property — usually real estate or stocks, but also including artwork and collectibles — and its selling price. The basis is usually the purchase price of property.
If you purchased a house for $250,000 and sold it for $450,000, you would have $200,000 of “gain” ($450,000 - $250,000 = $200,000).
However, the basis can be adjusted if you spend money on capital improvements. For instance, if after buying your house you spent $50,000 updating the kitchen, the basis would now be $300,000, and the gain on its sale for $450,000 would be $150,000 ($450,000 - ($250,000 + $50,000) = $150,000).
How Much Would My Capital Gains Tax Be?
It depends, but assume 15 percent federally, unless you have either very low or very high income, plus whatever your state’s tax is (let’s assume 5 percent, for a total of about 20 percent).
Using those assumptions, the tax on $200,000 of gain would be about $40,000. (However, there are exceptions that can depend on such factors as how long you own the property, what state you live in, or whether your total income is above a certain threshold.)
Avoiding Capital Gains Tax
Fortunately, when you inherit real estate, the property’s tax basis is “stepped up,” which means the value is re-adjusted to its current market value and often reduces or entirely eliminates the capital gains tax owed by the beneficiary.
For example, Sally’s parents purchased a house years ago for $100,000 and bequeathed the property to Sally when they pass away. When Sally inherits the property, it’s now worth $200,000.
Below are a few scenarios for how much profit from the sale of the house would be subject to capital gains taxes:
Sally Sells the Property Immediately
Sally receives a step-up from the original cost basis from $100,000 to $200,000 (the value at the time of her parent's death). If she sells the property right away, she will not owe any capital gains taxes.
Sally Holds the Property and Sells When the Property Appreciates
Several years pass, and the real estate is worth $400,000. If Sally sells now, the difference between the stepped-up basis of $200,000 and the current value of $400,000 is subject to capital gains. In this case, Sally will pay capital gains tax on $200,000.
Sally Lives in the House and Sells When the House Appreciates
If Sally lives in the house for at least two years before selling, Sally can exclude up to $250,000 ($500,000 for a couple) of her capital gains from taxes. This is known as the personal residence exclusion.
If the property sells for $400,000, she would be able to exclude the $200,000 in appreciation (the difference between the sale value and the stepped-up basis) that would otherwise be subject to capital gains.
On the other hand, if Sally's parents had gifted the same property to her before their deaths, as opposed to bequeathing it to her, the tax basis of $100,000 would not be stepped-up.
If Sally sold the house, she would have to pay capital gains taxes on the difference between $100,000 and the price when she sold it.
(Note that if Sally’s parents had wanted Sally to have the house while they were still alive, they might have wanted to think about options other than gifting the house, as gifting it could result in estate tax consequences. For instance, they could have considered selling the house to Sally or putting it in a trust.)
Sally Disclaims the House to Avoid Taxes
Sally chooses not to inherit the real estate and ensures that she won’t pay taxes on the property next year. The house will then go to the next beneficiary in line.
How Is the Cost Basis of a Property Determined?
The cost basis of a property you inherit is usually how much it was worth at the time you inherited it.
The best way to determine cost basis of a property you inherit is to get an appraisal of a property's fair market value.
You might also consider using the tax assessment. However, tax assessments are often low, which would mean a higher capital gain for you when you sell the property.
Another alternative might be to secure a written statement from your real estate agent. While this would not have the weight with the IRS of an official appraisal or tax assessment, it may pass muster if done in good faith.
A Note Regarding the Stepped-Up Basis
In 2021, legislation was introduced in Congress that proposes eliminating the basis "step up" This Sensible Taxation and Equity Promotion (STEP) Act could affect heirs who inherit property.
While it is not yet known whether the STEP Act will ever become law, its introduction suggests the possibility that lawmakers are looking to make significant tax law changes that could affect your estate planning in the future.
Capital Gains Taxes in a Nutshell
Take care not to underestimate the impact of capital gains tax on inherited property. The capital gains tax rate will depend on the length of time that you hold the property; long-term rates apply if you hold the property for more than one year.
With proper planning, you can avoid paying high capital gains taxes on assets you inherit. If you have inherited property or anticipate that you will in the future, the advice of an estate professional is invaluable.
Contact an estate planning attorney in your area to learn more about how capital gains taxes can affect you, including ways to lower — or altogether eliminate — your capital gains tax.
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Last Modified: 11/28/2022
As an expert in estate planning and tax law, I've navigated the intricate details of capital gains taxation, especially in the context of inherited property. Understanding the nuances of the tax system is crucial to help individuals preserve wealth and minimize tax liabilities. I've delved into the complexities of the stepped-up basis, capital gains calculations, and the potential impact of legislative proposals such as the Sensible Taxation and Equity Promotion (STEP) Act.
Let's break down the key concepts discussed in the article:
1. Capital Gain and Basis Adjustment:
Explanation: Capital gain is the difference between the basis (usually the purchase price) of a property and its selling price. The basis can be adjusted by capital improvements.
Example: If a house is bought for $250,000 and sold for $450,000, the capital gain is $200,000 ($450,000 - $250,000).
2. Capital Gains Tax Calculation:
Explanation: Capital gains tax is calculated based on the gain and can vary depending on factors like income and state tax rates. A common assumption is a 15% federal tax, plus a state tax (e.g., 5%), resulting in a total of about 20%.
Example: For a $200,000 gain, the tax could be approximately $40,000.
3. Stepped-Up Basis for Inherited Property:
Explanation: When inheriting real estate, the property's tax basis is "stepped up" to its current market value, potentially reducing or eliminating capital gains tax for the beneficiary.
Example: If a property bought for $100,000 is inherited and now worth $200,000, the stepped-up basis is $200,000.
4. Scenarios for Capital Gains Tax on Inherited Property:
a. Immediate Sale: No capital gains tax if sold immediately after inheritance. b. Hold and Sell Later: Tax on the difference between the stepped-up basis and the selling price. c. Personal Residence Exclusion: If the property is lived in for at least two years, up to $250,000 (or $500,000 for a couple) of capital gains can be excluded.
5. Disclaiming Inherited Property:
Explanation: Choosing not to inherit the property to avoid associated taxes. The property passes to the next beneficiary.
6. Cost Basis Determination:
Explanation: The cost basis of inherited property is usually its fair market value at the time of inheritance. Options for determining it include appraisal, tax assessment, or a real estate agent's statement.
7. Legislation Impacting Stepped-Up Basis:
Explanation: The introduction of the STEP Act in 2021 suggests potential changes to the stepped-up basis, impacting heirs who inherit property. The future implications remain uncertain.
8. Capital Gains Taxes Considerations:
Advice: Capital gains tax impact depends on property holding duration, and proper planning can help avoid high tax payments. Consultation with an estate planning attorney is recommended.
Given my expertise in this domain, I strongly advise individuals dealing with inherited property to seek professional guidance from an estate planning attorney. They can provide personalized advice and strategies to manage capital gains taxes effectively, considering the evolving legislative landscape.
