As an executor or trustee, you're likely to get questions from beneficiaries about the tax consequences of inheriting property. (And because you're probably an inheritor yourself, you may have your own questions as well.) Beneficiaries generally do not have to pay income tax on property they inherit – with a few exceptions. But if they inherit an asset and later sell it, they may owe capital gains tax.
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.
But what is your tax basis when you don't buy something, but inherit it? The tax laws say that your tax basis is 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 her tax basis was only $75,000, the amount she paid for the house 30 years ago.
The inheritor's tax basis is called a "stepped-up" basis, because the basis is stepped up from the previous owner's purchase price to the date-of-death value. And if property is held for a long time, its value generally does go up. But the basis could be stepped down, 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.
Note for very large estates: If you're working with an estate that's may owe estate tax—that means there must be well over $12 million in taxable assets—then the basis may be figured differently. Instead of the date of death value, the estate can choose an alternative valuation date of six months after the death. See an estate tax expert if this is an option for you.
A high tax basis is good. That's because when someone sells an inherited asset, long-term 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.
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 stepped-up 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. Currently, the tax rate is 15%.
Tax basis gets a little more complicated when 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.
When property is held by two owners in joint tenancy, only half of it gets a stepped-up 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 stepped-up tax basis in the half she inherits. She already owned the other half-interest, so her basis stays the same. That means that her new basis is $175,000. (The basis in her original half-interest is still $75,000, and the basis of the half-interest she inherits is $100,000.)
In community property states, married couples get a tax advantage. Both halves of community property (owned by the couple together) get a stepped-up basis when one spouse dies and the other becomes sole owner. So in the example above, the surviving spouse would have a new stepped-up basis of $200,000 after her husband's death.