Capital Gains Tax on Inherited Assets
As an heir you may have questions about the tax consequences of inheriting a real estate property. Beneficiaries generally do not have to pay income tax on property they inherit – with the common exception of money withdrawn from an inherited retirement account (IRA or 401(k) plan). But if you inherit an asset and later sell it you may realize a taxable capital gain.
Below is a recap, for informational purposes only, of the most common situations involving capital gain and inherited real estate property.
To understand capital gains tax, you must understand the concept of tax basis. The "tax basis" of an asset is the value that’s used to calculate the taxable gain or loss when the asset is sold.
Usually, the tax basis is the price the owner paid for the asset. For example, if you bought a house for $100,000, your tax basis would be $100,000. If you sold it a month later for $120,000, your taxable gain would be $20,000.
What is your tax basis when you don’t buy something, but inherit it?
The tax law says that your tax basis is generally the value as of the previous owner’s date of death. For example, if a son inherits a house from his mother that’s worth $200,000 as of her death, his tax basis is $200,000. It doesn’t matter that the deceased mother tax basis was only $75,000, the amount she paid for the house 30 years ago.
The inheritor’s tax basis is also known as the "fresh start basis" because the basis is recalculated from the previous owner’s purchase price to the date-of-death value. If property is held for a long time, its value generally does go up. But the basis could be reduced, too, if the property was worth less when the person died than it was when it was bought. What matters is simply the date-of-death market value.
Be aware that for very large estates if the estate owes estate tax (that means there must be more than $11.4 million in net assets), the basis may be figured differently. Instead of the date of death value, the executor can elect an alternative valuation date of six months after the death.
Capital Gains Tax
When someone sells an inherited asset capital gains tax will be due on the difference between the sales price and the tax basis. The higher the basis, the smaller the difference between it and the sales price. When an inherited asset is sold the result is always treated as a long term capital gain or loss, regardless of how long the asset was owned by the original owner or the heir.
For example, take that house inherited by a son from his mother with a date-of-death value of $200,000. If the son promptly sells it for $200,000, no tax will be owed, because he gets a fresh start tax basis of $200,000. But if his tax basis had been the same as his mother’s, $75,000, then he would have owed capital gains tax on his gain of $125,000 on the same transaction.
Jointly Owned Property
Tax basis gets a little more complicated when a property is co-owned and one of the owners dies. It’s a common situation, of course, because many couples own valuable property together and leave their shares to each other. There are also situations where unmarried family members own property as joint tenants, such as when siblings inherit part of a parent’s home or sometimes a parent might gift part of their resident to a child in order to avoid probate.
Joint tenancy property
When a property is held by two owners in joint tenancy generally only half of it gets a fresh start tax basis when the first owner dies. For example, say a couple owns a house worth $200,000; they paid $150,000 for it. If one of the owners dies, the survivor gets a fresh start tax basis in the half he or she inherits. They already owned the other half-interest, so their basis stays the same. That means that the new basis is $175,000. The basis in the original half-interest is still $75,000, and the basis of the inherited half-interest is $100,000.
In community property states such as California married couples get a tax advantage. Both halves of community property (owned by the couple together) get a fresh start tax basis when one spouse dies and the other becomes sole owner because each spouse legally owns 100% of all community property rather than each of them owning 50%. So in the example above, the surviving spouse would have a new fresh start tax basis of $200,000 after the first spouse dies.
When a gift is made the recipient’s basis generally is what the giftor’s basis was prior to the gift. There is a weird quirk however- if it is sold at a gain then the giftor’s basis is used, but if sold at a loss the basis to calculate this loss is the lesser of the giftor’s basis or the fair market value of the gift at the time of transfer. This minimizes the capital loss that can result from the sale of a gift and prevents taxpayers from shifting an asset with an unrealized loss to someone else to offset an otherwise taxable capital gain.
This summary is provided to you for informational purposes only. Please seek the advice of your tax advisor and/or estate lawyer for your specific circumstances.
Sources: www.alllaw.com, Barnett Accounting