A critical goal for many investors is to preserve and enhance the value of the assets they can distribute to their heirs. When a person dies, their assets typically enter probate for distribution. The asset's value is determined before disposition during the probate process. That's one reason why the step-up provision of capital gains taxation is an integral aspect of estate planning.
Estate planning is the process of arranging for the future transfer of one’s assets. Typically, a will is a primary tool for distribution, sometimes in conjunction with one or more trust accounts. The estate includes cash, personal property, personal and investment real estate, stock and other securities, valuable items like art and collectibles, life insurance policies, and any debts and obligations.
What taxes do heirs have to pay?
While the US does have a federal estate tax, the threshold for exemption is very high. Only estates with a total value of over $12.06 million are taxed (double that for couples who file jointly). For those estates that exceed the threshold limit, the tax rate is 40 percent, so it can be a substantial bite if not mitigated. Some states have estate taxes with lower minimum inclusions, but typically with exceptions for close family members.
In most cases, heirs don’t pay capital gains taxes. Instead, the asset is valued at a stepped-up basis—the value at the time of the owner’s demise. This tax provision is huge for many heirs since they may inherit property that the giver has owned for a long time.
Suppose that you inherit an investment property. Suppose your father purchased the property twenty years ago for $100,000, but it's now worth $2,000,000. The capital gain on that property is $1.9 million, which could be subject to a significant tax bill, depending on your tax bracket. Instead, you receive the property at its current value and pay no tax on the gain to date.
What other assets benefit from a step-up in basis?
In addition to commercial and investment property, other investments are typically eligible for the step-up treatment. These include:
- Business equipment
- Investment accounts, not including retirement accounts
- Artwork and antiques
- Jewelry, collectibles, and precious metals
But not these:
- CDs
- Money market accounts
- Pensions
- Tax-deferred annuities
- Retirement accounts like 401(k)s and IRAs
- Assets in an irrevocable trust
When would capital gains taxes be due?
If you inherit an asset subject to capital gains, you pay the tax when you trigger recognition of the gain. For example, suppose you inherit real estate. You won’t owe capital gains taxes on any appreciation that occurred between the time the asset was acquired and the time it passed to you. However, it may continue to increase in value after you inherit it. In that case, if you sell the property, you will realize a capital gain and be subject to the taxes on that amount. Under those circumstances, you would use Form 8949 and Schedule D to report the sale in the tax year that you sell the property.
Of course, if you prefer to defer the payment of the capital gains tax, you can consider executing a 1031 exchange before you decide to sell.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Hypothetical examples shown are for illustrative purposes only.
Costs associated with a 1031 transaction may impact investor's returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
