An inheritance is a windfall that can absolutely help someone’s financial situation – but it can make your taxes tricky.If you inherit property or assets, as opposed to cash, you generally don’t owe taxes until you sell those assets. These capital gains taxes are then calculated using what’s known as a stepped-up cost basis. This means that you pay taxes only on appreciation that occurs after you inherit the property. A financial advisorcan help ensure that you are filing your returns correctly.
Key Takeaways
- There are three main taxes to be aware of in regards to estates and inheritances: estate taxes, capital gains taxes and inheritance taxes.
- Understanding stepped-up basis will play a massive role in planning out the potential tax liability of your inheritance.
- With proper planning, you may be able to minimize the taxes charged on your inheritance.
If You Inherit Property, You Won’t Necessarily Pay Taxes
It isn’t a guarantee that you’ll owe a bunch of tax on any property that you inherit but it’s important to fully understand what you could owe if you just inherited an asset. Three main types of taxes cover inheritances:
- Inheritance taxes:These are taxes that an heir pays on the value of an estate that they inherit. There are no federal inheritance taxes and only six states levy any form of inheritance tax. Given the state-specific nature of inheritance taxes, this subject is beyond the scope of this article.
- Estate taxes:These are taxes paid out of the estate itself before anyone inherits from it. The estate tax has a minimum threshold. In 2024, that threshold is $13.61 million or $27.22 million for married couples. In 2023, that threshold is $12.92 million or $25.84 million for married couples. As with all other tax brackets, the government only taxes the amount that exceeds this minimum threshold, meaning that if your taxable estate is worth $13,610,001 in 2024 the government will levy taxeson just $1. The remainder passes tax-free.
- Capital gains taxes:These are taxes paid on the appreciation of any assets that an heir inherits through an estate. They are only levied when you sell the assets for gain, not when you inherit.
Cash that you inherit is taxed through either inheritance taxes (when applicable) or estate taxes. In the case of inheritance taxes, it is your responsibility to file and pay this tax. In the case of an estate tax, the IRS taxes the estate directly. As a result, it is uncommon for an heir to owe any taxes, including income tax, on inherited cash.
The IRS does not automatically tax any other forms of property that you might inherit. This means that if you inherit property, stocks or any other form of asset, you generally will not owe taxes when you inherit. For example, if you inherit your grandparents’ house, the IRS will not tax you on the value of the property when you receive it.
There are exceptions to this rule in certain specific circ*mstances. Most often these exceptions apply to assets that generate revenue, such as income investments, retirement accountsor ongoing businesses. You will, however, owe capital gains taxes if you choose to sell this property.
Capital Gains Are Taxed on a Stepped-Up Basis
When you inherit property, whether real estate, securities or almost anything else, the IRS applies what is known as a stepped-up basis to that asset. This means that for tax purposes the base price of the asset is reset to its value on the day that you inherited it. If you inherit property and then immediately sell it, you would owe no taxes on those assets.
The rules are the same whether you jointly own the property or not. Capital gains tax on the jointly owned inherited property will be evenly split, based on the ownership stake, for each owner that inherited a piece of that property.
Capital gains taxes are paid when you sell an asset. They are levied only on the profits (if any) that you make from this sale. For example, say that you buy a stock for $10. Later on, you sell that same stock for $50. You will owe capital gains taxes on the $40 that you made from this transaction.
Two prices are involved in establishing a capital gain tax: The sale price (how much you sold the asset for) and the original cost basis (how much you bought it for). In our example, the sale price of this stock is $50 and the original cost basis is $10. You are taxed on the difference which, again, brings us to $40 in taxable income.
Now consider the scenario that your grandparents bought their house years ago for $50,000. Since then it has skyrocketed in value and is worth $800,000. If they were to sell the house, they would potentially pay capital gains taxes on $750,000. (Keep in mind that if the property is a primary home for two of the previous five years, the IRS allows married couples who file jointly to exempt the first $500,000 in profits from gains taxes. Individuals can exempt the first $250,000.)
Sale price ($800,000) – Original cost basis ($50,000) = $750,000
Instead, however, they die and pass the house down to you. At the moment you inherit, the IRS will consider the house’s original cost basis stepped up to the current market value. This means that if you sell it immediately, you will pay no capital gains taxes:
Sale price ($800,000) – Stepped-up original cost basis ($800,000) = $0.00 taxable capital gains
On the other hand say that you hold the house for a year, during which time the price of this house goes up by another $100,000. If you sell it, you would owe capital gains taxes only on $100,000:
Sale price ($900,000) – Stepped-up original cost basis ($800,000) = $100,000 taxable capital gains
The stepped-up cost basis means that it is relatively rare for heirs to pay significant taxes on any amount of inheritance.
Bottom Line
There are some ways to avoid paying capital gains tax oninherited propertythat are worth considering if you’re the beneficiary of an estate or trust.When you inherit property, the IRS applies what is known as a stepped-up cost basis. You do not automatically pay taxes on any property that you inherit. If you sell, you owe capital gains taxes only on any gains that the asset made since you inherited it. You may want to talk to a professional advisor to make sure you plan your finances out correctly with the capital gains tax in mind.
Capital Gains Tax Tips
- Capital gains can be one of the most complicated sections of the tax code. A financial advisor can clarify how best to handle these situations.Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Use SmartAsset’sfederal income tax calculator to get a quick estimate of what you will owe. This will aid you in your tax planning for the past, current and future years.
Photo credit: ©iStock.com/designer491, ©iStock.com/designer491, ©iStock.com/skynesher
