UNDERSTANDING CAPITAL GAINS
& Estate Taxes
Estate planning and capital gains often overlap, especially when assets change hands after someone dies. How those assets are valued and eventually sold can create tax consequences for heirs.
To help clarify things, here’s a quick look at how capital gains tax works within an estate:
01. What Are Capital Gains?
Capital gains refer to the profit made from selling an asset, such as stocks, real estate, or other investments, for more than the original purchase price.
There are two types of capital gains:
Short-term capital gains: Profits from assets held for one year or less, taxed at ordinary income tax rates.
Long-term capital gains: Profits from assets held for more than one year, taxed at lower rates (0%, 15%, or 20%, depending on the taxpayer’s income).
02. Step-Up in Basis for Inherited Assets
One key tax benefit in the context of estates is the step-up in basis.
Basis refers to the original value of an asset, typically the purchase price. When you sell an asset, the capital gain is calculated as the difference between the sale price and the basis.
When someone inherits an asset, they often receive a stepped-up basis, which means the asset’s basis is "stepped up" to its fair market value (FMV) at the time of the original owner's death.
Example: If a person bought a house for $200,000 and it’s worth $500,000 at the time of their death, the basis is stepped up to $500,000 for the heirs. If the heir sells the house for $500,000, there is no capital gains tax, since the basis and sale price are the same.
03. Impact of the Step-Up Basis
Reduction of capital gains: The step-up in basis significantly reduces or eliminates capital gains tax for heirs who sell inherited property shortly after the original owner's death.
Long-term impact: If the heirs hold onto the asset for some time and it appreciates in value, they will owe capital gains tax on the difference between the sale price and the stepped-up basis when they eventually sell the asset.
Example: Using the previous scenario, if the heir holds the house for several more years and sells it later for $600,000, they would owe capital gains tax on the $100,000 difference between the $500,000 stepped-up basis and the $600,000 sale price.
| Short-term capital gains: Profits from assets held for one year or less, taxed at ordinary income tax rates.
04. No Step-Up in Basis for Gifts
It’s important to note that assets transferred as gifts (rather than inherited at death) do not receive a step-up in basis.
Example: If someone gifts an asset to a relative during their lifetime, the recipient takes on the original basis of the giver. So, if the asset was purchased for $200,000 and later gifted when it was worth $500,000, the recipient’s basis remains $200,000. If they sell it for $500,000, they would owe capital gains tax on $300,000 (the difference between the sale price and the original basis).
07. Capital Gains Exclusion for Primary Residences
There is a special capital gains exclusion for the sale of a primary residence: Individuals can exclude up to $250,000 of capital gains ($500,000 for married couples) from the sale of their primary home, provided they have lived in the home for at least two of the five years before the sale.
However, this exclusion generally doesn’t apply to inherited property unless the heir makes the home their primary residence. So, if an heir sells an inherited home and doesn’t live in it as their primary residence, the step-up in basis would be the main protection against capital gains tax.
08. Capital Gains in Estates with Appreciated Assets
Appreciation after death: Any appreciation in the value of an asset after the decedent’s death (i.e., after the step-up in basis) will be subject to capital gains tax when the asset is sold. This is why timing the sale of inherited assets can be crucial in minimizing tax liabilities.
Deferred gains: For assets like real estate or stock, where value continues to grow, heirs may eventually pay capital gains tax, but only on the appreciation that occurs after they inherit the asset.
10. State Capital Gains Taxes
Some states impose their own capital gains taxes, which may add to the federal capital gains tax burden. Heirs should check their state’s tax laws to understand potential additional taxes on the sale of inherited assets.
05. Estates and Capital Gains on Sale of Assets
Capital gains during estate administration: If the estate sells an asset (like real estate or stocks) before distributing it to heirs, the estate itself may be liable for capital gains tax. The capital gain would be calculated based on the difference between the asset’s basis (which would have stepped up to the fair market value at the time of death) and the sale price.
Example: If an estate sells a stock portfolio that was worth $100,000 at the time of death (the stepped-up basis) and it’s sold for $120,000, the estate would owe capital gains tax on the $20,000 gain.
06. Holding Period for Inherited Assets
For tax purposes, assets inherited from an estate are automatically considered long-term, regardless of how long the heir has actually held the asset. This means that when an heir sells an inherited asset, it will qualify for the lower long-term capital gains tax rates (0%, 15%, or 20%), even if they’ve held it for less than a year.
Gifts, on the other hand, retain the original holding period. If the original owner held the asset for less than a year before gifting it, it would be subject to short-term capital gains tax upon sale by the recipient.
09. Capital Gains on Retirement Accounts (IRAs, 401(k)s)
Retirement accounts such as IRAs and 401(k)s do not receive a step-up in basis. Instead, withdrawals from inherited retirement accounts are typically subject to income tax rather than capital gains tax.
The beneficiaries of retirement accounts will need to pay income taxes on distributions, depending on their tax bracket, but not capital gains tax on the appreciation of the investments within the account.
| Long-term capital gains: Profits from assets held for more than one year, taxed at lower rates (0%, 15%, or 20%, depending on the taxpayer’s income).
Summary of Capital Gains & Estates
The step-up in basis is a major tax benefit that reduces or eliminates capital gains taxes on inherited property, by resetting the asset’s basis to its fair market value at the time of the decedent’s death.
If an heir sells the inherited asset shortly after inheriting it, they likely won’t owe capital gains tax. However, if they hold the asset and it appreciates, they will owe capital gains tax on the difference between the stepped-up basis and the sale price.
Gifts during the giver’s lifetime do not receive a step-up in basis, meaning the recipient takes on the original purchase price as their basis, potentially leading to significant capital gains tax if the asset has appreciated.
Special rules apply to primary residences and retirement accounts, where different tax treatments, such as exclusions or income taxes, come into play.
Proper estate planning and understanding capital gains implications can help reduce the tax burden on heirs and beneficiaries. The estate planning attorneys at The English Law can advise you on capital gain taxes. Always seek the professional advice of a CPA or trusted tax adviser.
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If you have questions about capital gains or estate taxes in Kentucky or Indiana, do not hesitate to call our law firm locally at (502) 425-8717. You can also contact our real estate law firm online.