When you think about what your heirs will receive, your focus might be on wills, trusts, and dividing assets fairly. But you should also consider what kind of tax consequences those assets could trigger after you’re gone.
One question that often comes up is whether heirs will have to pay capital gains taxes on what they inherit. The answer depends on several factors, including what kind of assets you leave behind and when those assets are sold.
It’s easy to assume that once someone inherits an asset, the tax issues are settled. However, taxes on appreciation can come into play.
Appreciation refers to the increase in value from when you first acquired an asset to the time your heirs eventually sell it. This is where capital gains taxes enter the conversation.
What Are Capital Gains Taxes?
Capital gains taxes apply when someone sells an asset for more than its original purchase price. That gain is considered to be taxable income by the IRS.
Assets subject to capital gains tax include real estate, stocks, mutual funds, and other investments. The rate depends on how long you held the asset and your overall income.
If the asset was held for more than one year, it is considered a long-term capital gain. These gains are taxed at favorable rates of 0 percent, 15 percent, or 20 percent, depending on the seller’s income bracket.
Short-term gains, which are realized profits from assets held one year or less, are taxed at ordinary income rates.
Now here’s where estate planning changes things: When you pass away and someone inherits property from you, they do not automatically owe capital gains tax at the time of inheritance. Instead, they may receive a step-up in basis.
What Is a Step-Up in Basis?
A step-up in basis is one of the most important tax provisions for inherited assets. It adjusts the value of the asset to its fair market value at the time of your death. That becomes the new cost basis for your heir.
For example, imagine you purchased a stock for $10,000, and it is worth $50,000 at the time of your death. Your heir receives the stock with a new cost basis of $50,000. If they sell it right away for that amount, there is no capital gain, and therefore, no capital gains tax.
This tax rule can help preserve more wealth for your heirs. It also simplifies tax reporting, since your heirs do not need to track down decades-old records to determine your original purchase price.
When Do Capital Gains Taxes Apply to Heirs?
Your heirs will only face capital gains taxes if they sell an inherited asset for more than the stepped-up value. Using the earlier example, if your heir holds that $50,000 stock and it increases to $60,000 before they sell it, they will owe tax on the $10,000 gain.
That portion will be subject to capital gains tax based on their income level and how long they held the asset after inheriting it.
The same applies to inherited real estate. If your home has appreciated significantly over the years, the step-up in basis resets the value to its fair market price on the date of your death. If your heir sells it shortly afterward for that same value, they likely owe no capital gains tax.
However, if they rent the property, live in it for many years, or wait to sell, any increase in value after the date of inheritance could be subject to tax.
Are There Any Exceptions to the Step-Up in Basis?
There are. Assets held in certain types of irrevocable trusts may not receive a step-up in basis if they are removed from your estate for estate tax purposes. Additionally, assets given as gifts during your lifetime do not receive a step-up in basis.
Future Policy Changes Could Affect This
In recent years, there have been discussions at the federal level about reducing or eliminating the step-up in basis. While no legislation has passed, it is an area of ongoing policy interest. If that rule changes, it could significantly affect how heirs are taxed on inherited assets.
Staying informed and reviewing your estate plan regularly helps you adapt to any legal changes. Even if the rules stay the same, your financial situation may evolve. What made sense ten years ago might not work today.
Schedule a Consultation Today!
Our firm can help if you would like to work with a Petaluma, CA estate planning lawyer to put a plan in place. You can send us a message to request a consultation appointment, and we can be reached by phone at 707-769-9975.
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