What California Residents Need To Know About Federal Capital Gains Taxes
Capital gains taxes are taxes that you need to pay when you sell an asset that has gone up in value. You are taxed on the difference between what you bought the asset for (called "basis") and what you sold it for. Every piece of property has a tax basis. Generally, its the amount a person paid for the property. When you inherit an asset, you need to know what basis that asset has, so that, later, if you go ahead and sell it, you can calculate the capital gains taxes that will be due. (Currently, the federal long-term capital gains rate is 15% for most people; 20% + a 3.8% (23.8%) Medicaid surcharge for high earners.)
Generally, an asset is inherited with a basis equal to its date of death value. This is called a stepped-up basis, because an asset's basis is increased to reflect its value at the date of death. A step-up in basis is a big tax advantage, because it reduces the capital gains taxes due upon sale of an inherited asset. The higher the tax basis, the lower capital gains upon the sale of that property.
For example, Thomas purchased a house in 1980 for $100,000 and died in 2014. He left his house to his daughter, Linda. To determine the basis that Linda now has in the house, she needs to have the house appraised by an appraiser who is qualified to determine the value of houses in that area (not, for example, her Aunt Mildren who dabbles in real estate or an appraiser who specializes in jewelery or collectibles.) The appraiser determines that the house is worth $400,000 as of Thomas' date of death. Linda should now keep a copy of the appraisal with her valuable papers.
When Linda sells the house the following year for $450,000, she will be taxed on only that $50,000 gain, not on the difference between $100,000 (what her father paid for the house in 1980) and $450,000 (what she sold it for in 2015).
Stocks and bonds also receive a stepped-up basis when they are inherited at death. To determine the date of death value for stocks and bonds, the brokerage company needs to generate an estate valuation report (which averages the high and low trading value for each stock or bond on the day that a person died). For example, Thomas also owned a brokerage account with a portfolio of stocks and bonds. Linda called the company and requested an estate valuation report for the portfolio. She inherited the portfolio, the broker registered the new tax basis for each holding, and will now calculate the capital gains or losses generated for Linda based on these new values.
Married couples in community property states get a step in basis on the whole value of the property. Joint tenants only get a step up on the half of the property that they inherit, not on the half that they own already.
For example, if Fred and Joanne live in a community property state and own their house as community property, Fred will get a step in value for the entire house when Joanne dies. However, if Fred and Joanne owned the house as joint tenants, Fred would only receive a step up in basis on the half of the house that Joanne owned upon her death; his half would retain it's original purchase price as the tax basis.
Not all assets will get a step in basis at the death of the owner, though. First, retirement assets held in IRAs and 401(k)'s don't get a step up. Instead, the money that is withdrawn from these accounts is subject to regular income tax. Click here to read more about how retirement assets are taxed. Second, assets that are held in a Bypass or Credit Trust after the death of a first spouse, will pass to the beneficiaries without a step up. All such assets did receive a step up in basis after the first spouse's death, but, because they are held in an irrevocable trust after that death, will not receive a second step up at the second spouse's death.
For example, Kate and Harold created a living trust in 1999. The trust was designed to reduce possible estate taxes at the second spouse's death, and required that a Credit Trust be established after the first spouse died to hold one-half of the assets. The other half of the assets were to be allocated to a Survivor's Trust.
Harold died in 2003. At his death, half of the assets were allocated to a Credit Trust for Kate's benefit; the other half were allocated to the Survivor's Trust, also for her benefit. In 2003, their house was appraised at $250,000. One-half of the house was allocated to the Credit Trust and the other half was allocated to the Survivor's Trust. Kate died in 2010. At that time, the house was appraised at $500,000. When Kate's son, Jonathan, sold the house for $500,000, he had to pay capital gains on the half of the house that was held in the Credit Trust. That half of the house had a tax basis of $125,000 (1/2 the $250,000 value of the 2003 appraisal), so Jonathan owed capital gains taxes on $125,000 of gain. The other half of the house had a tax basis of $250,000 (1/2 of the 2010 value of $500,000), so no capital gains taxes were due on that half.
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