Whether the monetary value of an inheritance is large or small, receiving assets from a loved one can be incredibly overwhelming—emotionally and financially.
As you navigate your new circumstances, it's important to have realistic expectations and understand how much will ultimately be available to you. For instance, you'll want to know if you'll pay capital gains tax on inherited property and what other taxes might be a factor. Here's what to consider.
What are capital gains taxes?
Capital gains taxes apply when you sell something for more than you originally paid—however, things can quickly become complicated. Hypothetically, if you buy a property for $200,000 and sell it for $250,000, you may have a $50,000 capital gain. That gain could increase your tax bill, depending on the circumstances.
Not all assets are subject to capital gains taxes. For instance, you might invest in an annuity contract or an individual retirement account (IRA) and withdraw more than you paid in. However, annuities and retirement accounts are generally tax-deferred investments. Because of that, when you buy and sell inside the account, you typically don't recognize the growth as a capital gain on your next tax return. Instead, when you take distributions from those accounts (which might be many years later), the amount you withdraw might be treated as ordinary income. Again, this can get complicated. With nonqualified annuities, for example, you often withdraw the earnings first, which are treated as income. After that, you might get the assets out tax-free as a return of your original investment.
Even growth in assets like real estate and securities are tax-deferred, by some measures. You generally only report gains after you sell—but any appreciation before you sell is not taxable.
Life insurance is another exception. When the death benefit is paid directly to one or more beneficiaries, that payout is usually not taxable. That's especially true when a family member buys insurance to protect loved ones, but there are some cases in which insurance is taxable.
In some cases, it's possible to avoid capital gains taxes—at least partially—due to a step-up in basis. A step-up is an adjustment to an inherited asset's cost basis, making the new cost basis the asset's fair market value on the date of death. Assuming assets gain value over time, that often means increasing the cost basis (or stepping it up) to a value that is higher than the former owner's previous cost basis.
Not all assets benefit from a step-up in basis. While this is not an exhaustive list, some of the most common assets that get a step-up (assuming they're not held in a tax-deferred vehicle) include:
- Stocks and ETFs
- Mutual funds
- Real estate
For example, say a relative passes away and leaves you her home and some investments in a taxable brokerage account. If she originally bought those assets many years ago, there's a decent chance that the real estate and investment assets have gained value over the years. Put another way, the property's cost basis is likely low compared with the current market value. You didn't buy the assets yourself, but the assets gained value. So, you would likely benefit from a step-up in basis, allowing you to reset the cost basis based to the market values when your relative died.
How is inherited property taxed when sold?
When you inherit assets, the cost basis often resets to the asset's value on the date of death. This "step-up" in basis effectively removes the immediate capital gain, which works well for inheritors. Heirs generally do not take over a deceased person's original cost basis, so you would not realize a significant capital gain based on your relative's original purchase price. However, any price appreciation after the date of death could result in a capital gain.
Back to the hypothetical example above: If you inherit a home worth $250,000 on the decedent's date of death, your cost basis would be $250,000 if you qualify for a step-up in basis. That's true even if the owner originally bought the property for less than that (you would not be responsible for any gains in this example).
Passing assets to others at death can be a tax-friendly way to transfer property, although there are certainly other factors to consider. For example, it's important to understand if the assets you leave will benefit from the step-up in basis. If not, are they going to be treated as ordinary income (at least partially), or would they be tax-free to beneficiaries?
Tax rules are complicated, so speak with a CPA to review the specifics of your situation. Plus, things can change. For instance, you might get a step-up in basis for your relative's home—but what if you don't sell immediately? If the house gains value after the date of death, you could have a capital gain that results in taxes due after you sell. For instance, if the property value rises to $300,000 in six months and you decide to sell, you'd likely have a capital gain of $50,000. That gain is the difference between your sale price and the stepped-up basis, and you would generally owe taxes on that gain.
Do you have to pay inheritance taxes?
As the recipient of an inheritance, you're responsible for paying taxes on those assets. However, the term "inheritance tax" can be confusing. People may use the term in reference to a broad range of taxes, including a potential capital gains tax on inherited property. Some states also tax the value of assets you receive as an inheritance.
Only a handful of states in the United States have an inheritance tax, and those states tend to impose taxes only on large estates. For many people, inheritances fall below those thresholds. What's more, you can often inherit assets from a spouse without triggering inheritance taxes, and some dependents might also get favorable treatment. Still, if you receive a sizable legacy, it's wise to review the situation with a tax advisor.
There is no federal inheritance tax, but there may be estate taxes at the state or federal level. Estate taxes are entirely separate from state-levied inheritance taxes. In some cases, both types of taxes may apply.
Will you be responsible for paying estate tax?
Large estates may face estate taxes. However, most estates do not have to pay this tax either. In 2022, the federal estate tax only applies to estates
Some states also charge estate taxes, which are separate from the federal estate tax. As with inheritance taxes, a minority of states in the U.S. impose estate taxes, but the threshold to trigger these taxes may be lower than the federal threshold. For instance, Massachusetts may impose taxes on estates that
Estate taxes typically don't apply to property that passes to a spouse after death, but it's still smart to consult with an estate planning attorney and tax expert and make sure you're doing everything you can to manage your taxes. In contrast to inheritance taxes, which come from the recipient, the estate is generally responsible for paying estate tax.
Navigate your inheritance with confidence
Inheriting assets can be bittersweet. Although the event is often associated with losing a loved one, you may also receive resources that can improve your quality of life. It's crucial to understand how much you'll end up with after taxes and make smart decisions with the remaining funds.
In the most straightforward cases, you get a step-up in basis, which can prevent significant capital gains if you sell the property immediately after death. However, things aren't always so simple, and other factors such as additional taxes could come into play. Work with a CPA or tax attorney so you know what to expect when it comes to taxes, and consult with a