You may have built a portfolio of stocks, real estate, or other appreciating assets intending to pass them on to your heirs. If those assets have gained value over time, you might wonder if your beneficiaries will be responsible for paying capital gains taxes on the unrealized appreciation.
Indeed, understanding how capital gains taxes apply to inherited assets can help you plan more effectively and prevent unnecessary tax burdens on your heirs. Let’s look at the facts.
What Are Unrealized Capital Gains?
Unrealized capital gains refer to the increase in value of an asset that you own but have not yet sold. For example, if you purchased stock for $50,000 that is now worth $150,000, you have $100,000 in unrealized gains.
Since you haven’t sold the asset, you have not realized a gain, so you don’t have to be concerned about taxation. If you sell the asset during your lifetime, you will realize a gain.
You would owe capital gains taxes on the profit based on your original purchase price, also known as your cost basis. However, when assets pass to heirs, the tax treatment changes significantly.
The Step-Up in Basis
One of the most important tax advantages for inherited assets is the step-up in basis. When your heirs inherit appreciated assets, the cost basis is adjusted to the asset’s fair market value at the time of your death. This eliminates the unrealized capital gains that accumulated during your lifetime.
Using the same example, if your stock is worth $150,000 at the time of your passing, your heirs will receive a step-up in basis to that value. If they sell the stock for $150,000, no capital gains taxes will be owed. The unrealized gains from your lifetime effectively disappear for tax purposes.
What Happens If Your Heirs Hold the Assets?
If your heirs keep an inherited asset instead of selling it, they will not owe any capital gains taxes at the time of inheritance. Taxes only apply if and when they decide to sell. At that point, capital gains are calculated based on the difference between the sale price and the stepped-up basis.
For example, if your heir holds the stock and later sells it for $175,000, they will owe capital gains tax on the $25,000 profit above the stepped-up basis of $150,000. However, the $100,000 of unrealized gains from your lifetime is never taxed.
Are There Exceptions to the Step-Up Rule?
While the step-up in basis applies to most inherited assets, certain types of property do not qualify. Assets that are subject to income tax upon withdrawal, such as traditional IRAs and 401(k) accounts, do not receive a step-up in basis.
Additionally, if you make lifetime gifts of appreciated assets instead of passing them at death, your heirs inherit your original cost basis rather than receiving a step-up. If they later sell the asset, they will owe capital gains taxes on the entire appreciation from the time you originally acquired it.
Potential Changes to the Step-Up in Basis
Tax laws can change, and some proposals have sought to eliminate or modify the step-up in basis. While no changes are currently in effect, it’s important to stay informed about potential tax law updates that could impact estate planning.
If future changes are made to the tax code, planning strategies such as trusts or charitable giving may help mitigate potential tax burdens. Reviewing your estate plan regularly ensures that your heirs receive the maximum benefits under current laws.
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There are a lot of things to take into consideration when you’re planning your estate. When you work with our firm, we will learn about your situation and your objectives. All your questions will be answered, and we will make the appropriate recommendations.
At the end of the process, you will emerge a tailor-made plan that is ideal for you and your family. Going forward, we will always be available to update the plan when revisions become necessary.
You can call us at 913-521-2828 to schedule a consultation at our Overland Park, KS estate planning office, and you can use our contact form to send us a message.
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