When heirs inherit assets, they generally do not have to pay capital gains tax on the inheritance itself. However, if and when they decide to sell the inherited assets, they may owe capital gains tax based on the increase in value of the assets from the time they were inherited.
Step-Up in Basis
One of the key concepts important for understanding how capital gains tax applies to inherited assets is the “step-up in basis.” Here’s how it works:
- Basis: Basis is generally the cost of the asset when it was originally purchased. For example, if a stock was purchased for $50, that is its basis.
- Step-Up in Basis: When you inherit assets like stocks, real estate, or other appreciable investments, their basis is “stepped up” to their market value as of the date of the decedent’s death (or, in some cases, an alternate valuation date, 6 months after the date of death, if elected). This means if a stock was originally purchased for $50 but is worth $200 at the time of the decedent’s death, the basis is stepped up to $200.
- Capital Gains Calculation: If the heir later sells the inherited asset, the capital gains tax would only apply to the increase in value after the date of death. Using the previous example, if the heir sells the stock for $220, the capital gain would be $20 ($220 selling price – $200 stepped-up basis).
Implications for Heirs
- No Tax at Time of Inheritance: Heirs do not pay any capital gains tax simply for inheriting the asset. Taxes only come into play if and when the asset is sold.
- Lower Tax Liability: The step-up in basis can significantly reduce the capital gains tax liability by resetting the asset’s basis to its value at the time of inheritance, not its original purchase price.
Exceptions and Considerations
- IRAs and Retirement Accounts: Special rules apply to inherited retirement accounts like IRAs and 401(k)s. These do not receive a step-up in basis. Instead, heirs must pay income tax on distributions taken from these accounts, based on the deferred income taxes.
- No Step-Down: In situations where the value of an asset has declined since it was purchased, the basis is stepped down to the market value at the time of the decedent’s death. For example, if the decedent bought a stock at $200, and it was worth $150 at their death, and then you sell at $150, there is no capital gain.
- Estate Tax Consideration: While the step-up in basis can help reduce capital gains tax, it could potentially increase estate tax liability if the total value of the estate is high enough to trigger estate taxes. However, as of 2023, federal estate taxes only affect estates valued at more than $12.92 million (or $25.84 million for married couples).
Conclusion
While heirs typically benefit from the step-up in basis, reducing their capital gains tax liability upon the sale of inherited assets, it’s important to consider the full tax implications based on specific assets and their values. Consulting with a tax professional or estate planner can provide tailored advice to optimize tax outcomes and financial planning after receiving an inheritance. This approach ensures that you manage inherited assets in the most tax-efficient manner possible.