Got inheritance? If so, you might want to learn about one of several estate planning taxes in detail: capital gains tax on inherited property. Find out how capital gains tax can impact your estate plan, what to do about it, and things to watch out for. If you have additional questions, speak with a knowledgeable Orange County estate planning lawyer.
What Is Capital Gains Tax?
Whenever you have an investment that is sold for more than its original purchase price, the difference is your capital gains – that money is taxable. For example, let’s say that you bought a stock for $10 per share. Later, you sell it when it’s valued at $20 per share. You would owe capital gains tax on your profit of $10.
It is important to note that this tax grows in correlation with the size of your household income. The tax rate for capital gains is as low as 0% and as high as 37%, based on your income and whether the asset was a short-term or long-term investment.
Types of Taxes That Cover Inheritances
There are three main types of taxes that cover inheritances:
Inheritance Taxes
An heir pays these taxes on the value of an estate that they inherit. There is no federal inheritance tax and only six states levy the tax: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. So if the decedent lived in one of those six states or if the property being passed on is located in one of the states, inheritance tax will apply. If you have to pay inheritance tax, your tax rates depend on how closely related you were to the decedent and the total fair market value of your inheritance. Unrelated individuals usually pay the highest rates, while surviving spouses and some other relatives are exempt. Inheritances below a certain value may also be exempt. Each state sets its own tax rates, but most states use marginal tax rates, where only the value within certain thresholds is taxed at a given rate.
Estate Taxes
These are taxes paid out of the estate itself before anyone inherits from it. In order to have the estate be subjected to these taxes, the estate has to be worth at least, $12.6 million. The government only taxes the amount which exceeds this minimum threshold. The remainder passes tax free.
Capital Gains Taxes
These taxes are paid on the appreciation of any assets that an heir inherits through an estate. They are only levied when you sell the assets for gain, not when you inherit.
How Are Capital Gains Taxed?
Two amounts are involved in establishing a capital gain tax: (1) The sale price of the asset and (2) the original cost basis (how much you bought it for). For example, if you own stock you originally bought for $100 and sell it for $200, you are taxed on the difference, which is $100–that is your capital gains, that is taxable income.
How Does Capital Gains Tax Affect Inherited Property?
When you inherit an asset of any kind, the IRS applies what is known as a “stepped-up basis” to said asset. What it means is the base price of the asset is reset to its value on the day that you inherited it. Therefore, if you inherit property and then immediately sell it, you would owe no taxes on those assets.
For example, say that you inherit your grandparents’ house which they bought years ago for $100,000. Today, it has an increased value and is worth $600,000. The IRS by way of the stepped up cost basis rule, considers the inherited property’s original cost basis stepped up to current market value. This means that (1) if you sell it immediately, you will pay no capital gains taxes:
- Sale price ($600,000) – Stepped-up original cost basis ($600,000) = $0.00 taxable capital gains
And (2) if you hold the house for a year, during which time the price of this house goes up by $100,000, and you sell it, you would owe capital gains taxes only on $100,000:
- Sale price ($600,000) – Stepped-up original cost basis ($700,000) = $100,000 taxable capital gains
Ultimately, the stepped-up cost basis means that it is relatively rare for heirs to pay significant taxes on any amount of inheritance.
How To Avoid Capital Gains Tax on Inherited Property
If you think you may be subject to capital gains tax on inherited property, here is some advice on how to avoid capital gains tax altogether:
- Sell the property right away. As you saw in the example above, when the step-up basis applies, there are virtually no capital gains made because the original purchase price of the property is updated to the fair market value at the time of death of the testator (or trustor if a trust was used) who gifted the property to you and you don’t allow the property a chance to increase in value.
- Move into the property. A simple option to avoid the tax altogether is by moving into it and making it your primary residence. You will only be subject to a possible capital gains tax if you sell a property you inherited.
- Turn your property into a rental or vacation home. You could lease the property to semi-permanent tenants in exchange for passive rental income. You could also consider using the property as a second home or vacation property that you can rent out part-time. Again, you will only be subject to a possible capital gains tax if you sell a property you inherited.
- Set up and review your Estate Plan proactively. This is more of a preventative approach. There are certain types of Trusts that allow you to avoid certain taxes entirely. Taxation follows ownership, and Trusts allow you to control your property without ownership. You can learn more about this option by contacting us as we can recommend strategies and provide you with the right trust for your particular needs.
Create Your Estate Plan With Evolution Tax and Legal
Capital gains can be one of the most complicated sections of the tax code. Fortunately Evolution Tax & Legal can clarify how best to handle these situations. If you’re ready to get answers to all your capital gains tax questions, contact us today for a free consultation!