When you inherit property, such as a house or stocks, the property is usually worth more than it was when the original owner purchased it. If you were to sell the property, there could be substantial capital gains taxes. Fortunately, when you inherit property, the property’s tax basis is “stepped up,” which means the basis would be the current value of the property.
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 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.
If you inherit a home, do you qualify for the $250,000/$500,000 home sale tax exclusion? The answer is no. However, you benefit from the stepped-up basis rules for inherited property. As a result, you may not need the exclusion when you sell the home.
You don’t usually pay tax on anything you inherit at the time you inherit it.
You may need to pay:
- Income Tax on the profit you later earn from your inheritance, eg dividends from shares or rental income from a property
- Capital Gains Tax if you later sell shares or a property you inherited
- Inheritance Tax
You could potentially be liable for three types of taxes if you’ve received a bequest from a friend or relative who has died: an inheritance tax, a capital gains tax, and an estate tax. An inheritance tax is a tax on the property you receive from the decedent.1 A capital gains tax is a tax on the proceeds that come from the sale of property you may have received.2, And finally, an estate tax is a tax on the value of the decedent’s property; it’s paid by the Estate and not the heirs, although it could reduce the value of the inheritance.
The death of a loved one can be a stressful and difficult time, including when it comes to matters involving their Will and Estate. Suppose you’re the beneficiary of a property (meaning the property passes to your ownership) as part of a deceased estate. In that case, you may be wondering whether you’ll need to pay capital gains tax (CGT) on the home if you choose to sell it.
This article aims to provide a general overview of when the Australian Taxation Office (ATO) says CGT may and may not be payable on the deceased estate property. However, this can be a complex topic, so it may be a good idea to seek professional advice on matters concerning a deceased estate in your particular circumstances.
Do Beneficiaries Pay Capital Gains Tax on Inheritance?
A Beneficiary will not usually be liable to pay Capital Gains Tax on their inheritance. However, if an asset is transferred to them from the Estate (such as shares or property, for example) and they then sell this at a later date for a profit, they may become liable for Capital Gains Tax at this stage.
However, if Capital Gains Tax is payable by the Estate this may impact the amount a Beneficiary will receive.
How Capital Gains Tax Works during Probate
The person responsible for dealing with probate after a person dies is called the Executor (if there was a Will) or the Administrator (if there wasn’t). In the interests of simplicity, we will refer to the Executor throughout this article, but please note that the same applies to the Administrator of an Estate.
The Executor will be responsible for carrying out the legal, tax and administrative work on the Estate. One of the Executor’s duties is to calculate and pay any tax that is due from the Estate, including Capital Gains Tax, Inheritance Tax and Income Tax (if applicable).
The time taken to complete the administration of a person’s Estate after their death is called the Administration Period.
During the Administration Period, the assets in that Estate will need to be either sold or transferred. If assets are sold for a profit (gain), then these may be liable for Capital Gains Tax. Also, if the deceased person sold any investments in the tax year leading up to their death, then these could also be liable for Capital Gains Tax.
If Capital Gains Tax is payable, the Executor will be responsible for settling this tax out of the Estate before distributing monies to the Beneficiaries. This means that the Beneficiaries will not be liable for Capital Gains Tax, as this will already have been settled before they receive their inheritance.
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 end, 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 the 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 worthless when the person died then 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 may owe estate tax—that means there must be well over $11 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%.
How Is Cost Basis Calculated on an Inherited Asset?
In reality, the vast majority of estates are too small to be charged federal estate tax, which, as of 2020, applies only if the assets of the deceased person are worth $11.58 million or more.1
And most states have neither an estate tax, which is levied on the Estate itself nor an inheritance tax, which is assessed against those who receive an inheritance from an estate.
A handful of states—Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania—still tax some assets inherited from the estates of deceased persons;2 a dozen states plus the District of Columbia continue to tax estates. Maryland collects both.
Whether your inheritance will be taxed, and at what rate, depends on its value and your relationship to the person who passed away. The value of the assets for tax purposes is calculated on what’s known as their cost basis.
If you choose to sell assets you inherited, you do not escape tax liability. However, if you sell them quickly, you’re subject to more favourable treatment for capital gains than is customary. No matter how long property or assets are actually held, either by the decedent or the inheriting party, inherited property is considered to have a holding period greater than one year.9
Because of that, capital gains or losses are designated as long-term capital gains or losses for tax purposes. Even if you sell them immediately, you avoid the less favourable treatment typically given to assets that are held for less than a year, which are usually taxed at your normal income tax rate.
State Inheritance Taxes
You probably won’t have to worry about an inheritance tax, either, because only six states collect this tax as of 2019: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania.5 If the decedent lived or owned bequeathed property in any of the other 44 states, you can collect your gift free of an inheritance tax—even if you live in one of these six states.
Property passing to a surviving spouse is exempt from inheritance taxes in all six of these states, and only Nebraska and Pennsylvania collect inheritance taxes on property passing to children and grandchildren. The Estate of the person who died usually pays Inheritance Tax. You may need to pay Inheritance Tax if the Estate can’t or doesn’t pay it.
You may need to pay Inheritance Tax on a gift the person gave you in the 7 years before they died. You may also need to pay it if your inheritance is put into a trust and the trust can’t or doesn’t pay. If the will says the Inheritance Tax should be paid out of the assets you’ve inherited, the Executor of the Will or Administrator of the Estate will usually pay it.
HM Revenue and Customs (HMRC) will contact you if you need to pay.
Whether you’ll have to pay CGT on any inherited property (or whether you are exempt or partly exempt) can depend on a number of factors. These include whether it was the deceased’s main residence, whether it had been used to generate an income (i.e., rented out or used as a home office), when the deceased passed away, and when they acquired the property, according to the ATO.
The ATO website says if you inherit a home and later sell it, or otherwise dispose of it, you may not need to pay CGT in the following scenarios:
- If the deceased person died before 20 September 1985, any capital gain you make when you dispose of the property is CGT-exempt, but any major capital improvements (such as a renovation) you made to it on or after this date may be taxable.
- If the deceased acquired the dwelling before 20 September 1985 but died on or after 20 September 1985, CGT does not apply, providing one of the following requirements is met:
Condition 1: You sell the property within two years of the person’s death (meaning it is sold under a contract and settlement occurs within two years). This applies whether or not you live in the property as your main residence or use it to earn an income during this time. You can also apply to have these two years extended if the delay in you selling the home is due to circumstances beyond your control.
Condition 2: From the time of the deceased’s death until you dispose of your ownership interest (such as by selling the property), the property is not used to produce an income (such as renting the property out) and is instead used as the main residence of either the spouse of the deceased when they died, another person with the right to occupy the home under the deceased’s will, or you as a beneficiary.
- Suppose the deceased acquired the dwelling on or after 20 September 1985 and the dwelling passed to you on or before 20 August 1996. In that case, you may be exempt from CGT provided you meet Condition 2 above, and the deceased also used it as their main residence from the date they acquired it until their death and did not use it to produce an income.
- If the deceased acquired the dwelling on or after 20 September 1985 and the dwelling passed to you after 20 August 1996, you may be exempt from CGT if you meet either Condition 1 or Condition 2 above, so long as the deceased was using it as their main residence and not to produce income just before they died.
If the property has been used to produce an income or was not the deceased’s main residence, the ATO says CGT may be payable on some or all of the capital gain. The ATO website has a questionnaire you can complete, to give you an indication of whether the dwelling is exempt from CGT, as well as advice on calculating partial exemptions (if eligible).
If you are not exempt from CGT, the ATO says you will need to know the cost base of the property, which is the market value of the property when the deceased acquired it or when they died, depending on your circumstances. This value will be used to calculate your capital gain.
Any income received after the person’s death, such as rent from a property or income from the person’s business, ‘belongs’ to their Estate. Usually, this type of income doesn’t have tax deducted before it’s received.
For this type of income, the Executor must report this to HMRC as part of probate, so that an appropriate amount of tax is calculated and paid by the Estate.
How much Income Tax the deceased’s Estate needs to pay depends on where the income is from.
Who Qualifies for the Home Sale Tax Exclusion
First, a little background. The tax law provides homeowners with a very generous tax exclusion when they sell their property. Up to $250,000 of any gain from such a sale received by a single homeowner is tax free. For married homeowners filing jointly, up to $500,000 of gain is excluded from income. To qualify for the exclusion, the home must have been used as the main home for two years out of the prior five years before the sale. For details see, the article “The $250,000/$500,000 Home Sale Exclusion.”
At the time you inherit a home, you won’t qualify for this exclusion. You’d have to move into the home and live there for at least two years to qualify. However, you may not really need exclusion because of the stepped-up basis rules.
How the Stepped-Up Basis Rules Affect People Who Inherit Property
“Basis” means an asset’s cost for tax purposes. To determine whether you have a profit or less when you sell an asset, you subtract its basis from the sale price. If you have a positive number, you have a gain. If you have a negative number, you have a loss.
The basis of a home you buy or build is its cost, plus any improvements you make while you own it. See Determining Your Home’s Tax Basis for details.
However, a home’s tax basis is determined in a different way when someone inherits a home after the owner dies. When you inherit property after the owner dies, you automatically receive a “stepped-up basis.” This means that the home’s cost for tax purposes is not what the now-deceased prior owner paid for it. Instead, its basis is its fair market value at the date of the prior owner’s death. This will usually be more than the prior owner’s basis.
The bottom line is that if you inherit property and later sell it, you pay capital gains tax based only on the value of the property as of the date of death.
Jean inherits a house from her father, George. He paid $100,000 for it over 20 years ago. George made $20,000 in improvements over the years, so his’s tax basis in his home just before George died was $120,000. However, when Jean inherits the home, its basis is stepped-up to its fair market value on the date of George’s death. Jean has the home appraised, and this value is set at $500,000. Jeans sell the house for $505,000 a few months after she inherits it. Her tax basis in the house is $500,000. She subtracts this amount from the sales price to determine her taxable gain: $505,000 sales price – $500,000 basis = $5,000 gain.
If you sell an inherited home for less than its stepped-up basis, you have a capital loss that can be deducted (assuming you don’t use the home as your personal residence). However, only $3,000 of such losses can be deducted against your ordinary income per year. Any excess must be carried over to future years to be deducted.
Exemptions From Inheritance Tax
Even in states that tax inheritances, family members are generally spared from tax, as are relatively small inheritances. Surviving spouses are exempt from inheritance tax in all six states.2 Domestic partners, too, are exempt in New Jersey.Descendants pay no inheritance tax except in Nebraska and Pennsylvania.
Both the thresholds at which inheritance tax kicks in and the rates charged typically vary by relationship to the decedent. Threshold amounts vary between $500 and $40,000, and the tax rates range between 1% and 18%.2 The specific rules in each state are complex. Generally, though, the stronger your familial relationship to the decedent, the less likely it is that you’ll have to pay tax, and the lower the rate.
The thresholds are for each individual beneficiary, and the beneficiary must pay the tax. Bear in mind that taxation applies only to the amount of the inheritance that exceeds the exemption. A state may charge a 13% tax on your inheritances, for example, if they’re larger than $10,000. Therefore, if your friend leaves you $20,000 in his will, you only pay tax on $10,000, for a bill of $1,300. You’d be required to report this information on a state inheritance tax form.