We just finished filing our 2021 taxes, and as a result, you may be wondering how you can reduce your tax burden (and maximize available benefits) for the 2022 filing year. Estate planning is often mistaken as a “set it and forget it” activity, and it can be surprising to some that it should be integrated as a part of your tax strategy as well. In reality, your estate plan can affect your taxes and it would behoove you to plan regularly and make any necessary changes. This guide will discuss one of several estate-planning taxes in detail: capital gains tax on inherited property. Keep reading to find out how capital gains tax can impact your Estate Plan, what to do about it, and things to watch out for in 2022.
What is Capital Gains Tax?
Capital gains tax is a tax that is levied any time an investment is sold for more than its original purchase price. When we talk about investments, we usually think about assets like stocks and bonds. For example, let’s say that you bought a stock for $5 per share. Later, you sell it when it’s valued at $10 per share. You would owe capital gains tax on your profit of $5.
The financial impact of this tax grows in correlation with the size of your household income. The tax rate for capital gains is as low as 0 percent and as high as 37 percent, based on your income and whether the asset was a short-term or long-term investment.
The tax may not feel like much when your income is modest. However, they can create quite the impact when your income, and thus your investments, grow. This is especially something to consider when you are planning an estate. It can be a major drawback when you work hard to create an inheritance for your loved ones and later find out that a large portion of it will get eaten by taxes.
That’s why it’s important to understand how this tax works, and how it can impact you in the context of your Estate Plan. Luckily, there are some strategies you can implement to reduce the impact or avoid it altogether. We will discuss these shortly.
First, we will explain how capital gains tax can affect inherited property. (Click on the link to be taken to a different article that explains further about how capital gains tax works. Then, come back here to learn more about how it can impact inherited property and new tax rules that might affect you in 2022.)
How Does Capital Gains Tax Affect Inherited Property?
Capital gains tax on estate property can kick in if the property is sold at a higher price than its purchase price. This means that the tax impacts the person who inherited property. If you are creating your Estate Plan and plan to pass property to your child for instance, then know that your child could be impacted by capital gains tax if they were to sell it. If you inherited a house from a relative, then you could pay capital gains tax if you sell the house.
If the property happens to be sold at a loss, then the person selling the property can claim a capital loss deduction. However, this is usually not the case as investments historically increase in value, especially real estate.
Luckily, the Internal Revenue Service (IRS) applies a rule called “stepped-up basis.” This rule calculates how much capital gains tax is owed by using the property value at the time of inheritance, versus its original purchase price. This provides immense relief for tax payers in most cases. Let’s use an example to help illustrate.
Let’s say your grandfather purchased a home in Burbank, CA in 1946 at the price of $10,000; it’s a year after World War II and the economy is booming. This is your childhood home, and you remember that your parents renovated it a number of times. Today, you find out that your late grandfather bequeathed the home to you through his Estate Plan. You feel ready for homeownership, but you live in New York City with no plans to move back home. You decide to sell the home to raise capital for your first home purchase.
This is where we run into a problem. According to Zillow, the average home price in Burbank, CA today is over $1.1 million. Without the step-up basis, you would be facing a huge tax bill.
Here, step-up basis comes to the rescue. The base value of the home is changed to the fair market value at the time you inherited it. You would only be liable for capital gains tax if you sell the home and make a profit from this stepped-up value. When the inheritance is planned well, then capital gains tax may be avoided completely. We’ll discuss some strategies shortly.
Before we do this, it’s important to note that tax laws and rules change often. What is true today may not be true tomorrow. We recommend staying on top of tax law adjustments and updating your estate planning strategy accordingly. Here are some capital gains tax changes to watch out for in the 2022 filing year.
Tax Law Adjustments to Watch Out for in 2022
Tax laws are often proposed with an expiration date, and changes in administration often lead to adjustments.
After coming into office, President Joe Biden proposed some new tax laws in 2021, which may be passed when current rules expire in 2022.
The proposed rules eliminate the step-up basis exemption on any inherited assets that have gained an excess of $1 million in value ($2.5 million if you are married and are filing jointly.) The difference in value is measured between the original purchase price and the fair market value at the time of death.
You would still benefit from the step-up basis rule if your inherited assets gained less than $1 million in value, or when the property was donated to charity.
Note that the estate and gift tax exemption is currently at $11.7 million ($23.4 million for married couples filing jointly). You can still bequeath and inherit property valued below the threshold without being subject to estate tax. However, any inherited property valued over this threshold would be exposed to double-taxation between estate tax and capital gains tax. Further, there is also a proposal to increase the capital gains tax top rate from 29 percent to 49 percent. (Percentages add together top rates for federal and state taxes.)
These proposed tax policies will mainly affect the ultra-wealthy starting in 2022. They are most likely to own property and assets that exceed exemption amounts. They are also most likely to face double-taxation. If you do not fall into this category, it’s still a good idea to keep an eye on capital gains tax rules. Real estate in particular is an example of a property that grows significant value over the years. It would not be an uncommon scenario for an unassuming American to inherit a house that has grown over $1 million in value. If the step-up basis exemption is removed for this threshold, then it is necessary to plan for capital gains tax.
Key Takeaways:
The Biden Administration’s proposed tax rules for 2022 include a removal of the capital gains tax step-up exemption for any assets that have gained over $1 million in value.
The value difference is measured between the value of the property at its original purchase and the time of death.
The exemption amount is $2.5 million if you are married and filing jointly.
Wealthier families owning assets worth over $11.7 million ($23.4 million if filing jointly) can face both capital gains and estate tax.
Property donated to charity is exempt from capital gains rules.
The top rate for capital gains tax may increase from 29 to 49 percent (state and federal rates combined.)
How to Avoid Capital Gains Tax on Inherited Property
If you think you may be subject to capital gains tax on inherited property, we have some good news for you. We have some advice below for how to avoid capital gains tax altogether (it’s perfectly legal), and we’ve taken the proposed tax changes into account:
Sell the property right away. When step-up basis applies, it could benefit you to sell the property as soon as you inherit it. There would virtually be no capital gains made because the original purchase price of the property is updated to the fair market value at the time of death of the Testator (or Trustor when a Trust was used) who gifted the property to you. If you sell the property right away, you’re not giving the property a chance to increase in value. The proposed new tax rules for 2022 will get rid of this exemption if the property is valued at $1 million over the original purchase price. If this applies, you may want to consider one of the next two options instead.
Move into the property. You will only be subject to a possible capital gains tax if you sell a property you inherited. A simple option to avoid the tax altogether is not to sell it by moving into it and making it your primary residence.
Turn your property into a rental or vacation home. There are valid reasons for not wanting to move into a house that you inherited. If it benefits you to retain ownership of an inherited property, consider turning it into a rental. You could lease the property to semi-permanent tenants in exchange for passive rental income. This could kickstart a portfolio of investment properties that can help secure your financial future. You could also consider using the property is a second home or vacation property that you can rent out part-time.
Set up and review your Estate Plan proactively. The advice provided above are reactive measures to hedge against capital gains tax. There is also a preventative approach: establish your Estate Plan early and review and update as necessary. By creating an Estate Plan, you have more control over your assets. For instance, there are certain types of Trusts that allow you to avoid certain taxes entirely. Taxation follows ownership, and Trusts allow you to control your property without ownership. Further, estate planning encourages you to look at your property and assets as a whole, resulting in tax-advantaged actions. This can help relieve tax burdens for your heirs later on. Find out more about taxes that can affect your Estate Plan and recommended strategies here.
Create Your Estate Plan Today
In this guide, we learned about how capital gains tax on inherited property is something to look out for. When planning for taxes, we often don’t think about our estate plans, but there are a number of tax policies that can affect your strategy.
These taxes can impact you even when you don’t have an Estate Plan. For instance, capital gains tax most likely impacts the individual who inherits a property, and not the person who gifted it to them. You could be the lucky person who inherits a piece of real estate tomorrow, but then are shocked at the tax bill when you sell it. This is why it’s helpful to think of estate planning as a multi-generational affair that considers the whole family as a whole.
When you set up your Estate Plan, be sure to think about how your approach might impact future generations. You can set it up in such a way that helps minimize the tax burden on your loved ones. You can also provide education so that your loved ones know what to do when they eventually inherit your property.
Last but not least, remember that tax rules can change. The Biden Administration promised to make changes to existing tax laws, and we revealed proposed changes to the capital gains tax rules in 2022. Even if you don’t think they apply to you, it’s always a wise idea to keep an eye on upcoming changes. Make sure to review and adjust your Estate Plan accordingly so that you can retain your wealth within the family as much as possible.
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