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.
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.
In addition to commercial and investment property, other investments are typically eligible for the step-up treatment. These include:
But not these:
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.