When you inherit assets, taxation might be a concern, especially if those assets appreciated in value. The tax rules governing inheritances are generally favorable to heirs but understanding how the capital gains tax applies is essential.
This post will explore the matter of capital gains taxes on inheritances, and we will also look at the broader tax framework related to estates.
How Capital Gains Tax Works
When you sell an asset that has increased in value, you “realize” a gain. If you have held the asset for more than a year, the gain is subject to long-term capital gains tax. The tax rate for long-term gains depends on your taxable income.
For those earning up to $47,025 no capital gains tax applies. If your income falls between $47,025 and $518,900, you will pay a 15% tax on long-term capital gains. For single filers earning over $518,900, the rate is 20%.
These are the 2024 thresholds, but the figures change annually with inflation adjustments.
Short-term capital gains, which are gains realized on assets held for less than a year, are taxed at your regular income tax rate. This will usually mean paying a higher rate compared to long-term gains.
Step-Up in Basis for Inherited Assets
When you inherit assets that appreciated during the decedent’s lifetime, the tax treatment is more favorable.
These assets receive a “step-up in basis,” which means the value is reset at the time of the decedent’s death. You would only be responsible for capital gains tax on any appreciation that occurs after you inherit the asset.
For example, if a decedent bought a piece of real estate for $100,000 and it was worth $500,000 at the time of their passing, your basis in the property would be $500,000. If you sold the property later for $600,000, you’d only owe capital gains tax on the $100,000 increase.
The Federal Estate Tax
Now, we have to move on to the bad news. There is a federal estate tax that can take a heavy bite out of your legacy. This tax carries an eye-popping 40 percent maximum rate, so it is a very big deal for high-net-worth individuals.
It is a problem that only applies to very wealthy people because there is a significant credit or exclusion. This is an amount that can be transferred before the estate tax would potentially be levied on the remainder.
At the time of this writing in 2024, the federal estate tax exclusion stands at $13.61 million. This is the highest it has ever been, and it is a product of a provision in the Tax Cuts and Jobs Act of 2017.
During the 2017 calendar year, the exclusion was $5.49 million. The provision that set the record-high estate tax exclusion will expire or sunset on January 1, 2026. At that time, the exclusion will revert back to the 2017 level indexed for inflation.
Federal Gift Tax
After the estate tax was enacted in 1916, people would just give away assets while they were living to avoid taxation. This practice was halted in 1924 when a gift tax was established.
It was repealed in 1926, but in 1932, the gift tax was reenacted. It has been in place ever since that time, and the gift tax and the estate tax were unified in 1976.
As a result of this unification, the multimillion-dollar exclusion is a unified exclusion. It applies to lifetime gifts and the estate that will be transferred after you are gone.
Annual Gift Tax Exclusion
In addition to the unified gift and estate tax exclusion, there is also an annual exclusion. You can give as much as $18,000 to any number of people or entities within a tax year free of transfer taxes.
You can also pay school tuition for students without incurring any transfer tax liability. The same thing applies to paying medical bills for others, including health insurance premiums.
State-Level Income and Inheritance Taxes
In addition to federal estate taxes, some states impose their own estate or inheritance taxes. An inheritance tax is imposed on each individual who receives a distribution from the estate, while estate taxes apply to the total value of the estate before it is distributed.
Only a handful of states impose inheritance taxes, but as luck would have it, there is a New Jersey inheritance tax. On the positive side, it does not apply to close relatives.
Some states also have their own estate taxes. If you inherit property in a state with an estate tax, and its value exceeds the state’s exclusion limit, you may face a tax bill even if the estate wouldn’t trigger federal estate taxes.
There is no New Jersey estate tax, but our neighbors in New York have an estate tax, and there are estate taxes in Connecticut, Maryland, and Massachusetts.
Window of Opportunity
If you will be exposed to the federal estate tax when the exclusion goes down to $5.49 million indexed for inflation, action is required. You have a limited window of opportunity to implement an estate tax efficiency strategy between now and 2026.
There are certain types of trusts that can be used to provide tax efficiency. First, you benefit from the fact that you remove assets from your taxable estate when you place them into a trust. Secondly, these trusts facilitate transfers that are discounted in some way.
We can help you implement a tax efficiency strategy if taxation is a factor for you. If you act before New Year’s Day in 2026, you can position yourself optimally in light of the circumstances.
Take Action Today!
Legal counsel is invaluable when you are crafting your legacy, even if taxes are not going to be a source of concern. When you work with our firm, we will make sure that you understand all of your options so you can make fully informed decisions.
To set the wheels in motion, call our Warren, NJ estate planning office at 908-222-8803 or send us a message through our contact page.
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