Nobody lives forever, and many investors begin to face this sad reality as they grow older. Some investors worry about the tax burden on their heirs upon receiving assets, especially those that have appreciated over time. So, it’s important to address the question, “Are unrealized gains taxed upon death?”
The answer is no, and the question is at the heart of a broader topic surrounding unrealized gains, inheritance, and a long-standing rule called the step-up in basis.
If you’re planning your estate or expecting to pass down assets, it’s essential to understand how these rules affect what your heirs might owe in taxes. Below, Realized 1031 has shared a definitive guide to help you out.
What Is Unrealized Gain?
Unrealized gain is the increase of an asset’s value that hasn’t been sold yet, hence the term “unrealized.” Meanwhile, realized gains are the profit you make after you sell an asset, such as real property. Let’s say that you own an apartment complex. You originally bought the property for $500,000. As the building appreciated, its current value is now $800,000. You haven’t sold it yet, so you have unrealized capital gains of $300,000. Once you sell it, this profit becomes taxable as capital gains tax. What about if you pass away?
The Angel of Death Loophole: Understanding the Step-up in Basis
Here’s where a critical tax provision comes into play: the step-up in basis. At death, the cost basis of most appreciated assets is “stepped up” to their fair market value at the time of the owner’s death. The new cost basis is the current FMV, with the entirety of your unrealized gain being eliminated.
In our example above, you managed to hold on to the apartment complex until you passed away. The value was $800,000, with $300,000 as the unrealized capital gains. In this instance, $800,000 becomes the new cost basis. In other words, there are no longer any gains.
Critics call this the “angel of death loophole” because it effectively erases decades of unrealized gains. Advocates argue it prevents heirs from being burdened with taxes they can’t afford to pay, especially when it comes to inherited homes, family businesses, or farmland.
Sample Scenario for Your Heirs
Let’s say that your only child inherits an apartment complex you owned. If the heir decides to sell the property immediately or close to the date of your death, it’s likely that they won’t pay any unrealized capital gains tax because the property hasn’t had time to appreciate yet. However, the longer your heir holds the property, the higher the chance of appreciation. When they eventually sell the asset, any appreciation will be taxable as a realized gain. Hence, it’s important to remember that just because the step-up in basis eliminates capital gains from the previous owner doesn’t automatically mean the current owner won’t have any tax liability.
Could Things Change in the Future?
The angel of death loophole has been held under scrutiny for a long time. There have been circulating proposals to eliminate this benefit for wealthy estates to replace it with realization upon death or a carryover basis. However, these proposals have yet to come to pass. If they do, such a change will have a significant impact on estate planning. Investors can only keep an eye out in case new laws come into effect in the future.
Wrapping Up: Unrealized Gains Taxation Upon Your Death
Unrealized gains of an appreciated asset will not be taxed upon the owner’s death. The cost basis instead resets to the current FMV thanks to the step-up in basis, essentially eliminating the unrealized gains for the heirs. This benefit helps your beneficiaries manage capital gains tax payments should they ever sell the asset. Make sure to consult with professionals during estate planning to understand how you can avoid any surprises in the future.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Article written by: Story Amplify. Story Amplify is a marketing agency that offers services such as copywriting across industries, including financial services, real estate investment services, and miscellaneous small businesses.
Sources:
https://tax.kenaninstitute.unc.edu/news-media/what-is-the-angel-of-death-tax-loophole/
https://www.klenklaw.com/blog/whats-angel-death-tax-loophole-care/
