Understanding Inheritance and Capital Gains Tax 

An inheritance can significantly improve one’s financial situation, but it also brings tax implications that must be carefully managed. If you inherit property or assets rather than cash, you generally don’t owe taxes until you sell those assets. At that point, capital gains taxes are calculated using what’s known as a stepped-up cost basis, meaning you only pay taxes on appreciation that occurs after inheriting the property. Consulting your tax professional can help ensure you navigate these tax complexities correctly. 

Key Takeaways 

  • There are three main types of taxes related to inheritances: estate taxes, capital gains taxes, and inheritance taxes. 

  • A stepped-up cost basis plays a crucial role in determining tax liability on inherited assets. 

  • With strategic planning, it is possible to minimize the taxes owed on an inheritance. 

Understanding Estate and Inheritance Taxes 

Not all inherited property is taxed, but it is essential to know the potential tax implications: 

1. Inheritance Taxes 

Inheritance taxes are levied on the value of an estate that an heir receives. There are no federal inheritance taxes, and only six U.S. states impose inheritance taxes. Since these taxes are state-specific, they are beyond the scope of this article. 

2. Estate Taxes 

Estate taxes are deducted from the estate before the inheritance is distributed. The federal estate tax threshold in 2025 is $13.99 million ($27.98 million for married couples). Any amount exceeding this threshold is subject to taxation, but only the excess amount is taxed. 

3. Capital Gains Taxes 

Capital gains taxes apply when an inherited asset is sold at a profit. However, these taxes are only assessed on the gain made after the asset is inherited, thanks to the stepped-up cost basis rule. 

Capital Gains and the Stepped-Up Basis 

When you inherit property, the IRS adjusts the cost basis of the asset to its fair market value at the time of inheritance. This means that capital gains taxes are only due on any increase in value after the inheritance date. 

For example: 

  • Suppose your grandparents purchased a house for $50,000. 

  • At the time of inheritance, the house is valued at $800,000. 

  • If you sell the house immediately at $800,000, you owe no capital gains tax. 

  • However, if you hold onto the house for a year and its value increases to $900,000, you will owe capital gains tax on the $100,000 gain. 

Capital Gains Tax Rates 

Capital gains are taxed at different rates depending on how long the asset is held: 

  • Short-term capital gains tax (for assets held less than one year) is taxed at ordinary income tax rates. 

  • Long-term capital gains tax (for assets held over one year) is taxed at 0%, 15%, or 20%, depending on your income level. 

Minimizing Capital Gains Tax on Inherited Property 

If you inherit property and wish to reduce capital gains tax liability, consider the following strategies: 

  1. Sell Immediately: Selling right after inheritance avoids capital gains tax because the stepped-up basis equals the sale price. 

  1. Convert the Property to a Primary Residence: If you live in the inherited home for at least two out of five years before selling, you may qualify for the home sale exclusion ($250,000 for single filers and $500,000 for married couples). 

  1. Utilize a 1031 Exchange: If the inherited property is an investment, you may defer capital gains taxes by reinvesting in another property through a 1031 exchange. 

  1. Gift the Property: Gifting to a beneficiary in a lower tax bracket may reduce the overall tax burden when they eventually sell the property. 

Summary

While inheriting property generally does not result in immediate tax liability, selling an inherited asset may trigger capital gains taxes. The stepped-up basis rule significantly reduces tax obligations, but proper planning can further optimize tax outcomes. Consulting your tax professional can help beneficiaries navigate tax obligations effectively and make informed financial decisions. 

 The information presented should not be used as the basis for any specific investment advice. Hypothetical examples are not intended to suggest a particular course of action.

 "Guardian, its subsidiaries, agents and employees do not provide tax, legal, or accounting advice. Consult your tax, legal, or accounting professional regarding your individual situation. The information provided is based on our general understanding of the subject matter discussed and is for informational purposes only."  7496976.2 Exp 04/27