Is There a Capital Gains Tax on Inherited Assets?

Q: In your weekly Newsday column, you recently wrote ‘After Congress passes a new federal estate law, the capital gains tax exemptions on inherited assets will be unlimited.’

I know there is no inheritance tax this year, but I thought there will be one next year. How do you know a new bill will approve an unlimited capital gains tax exemption? Does an unlimited exemption apply only to inherited homes, or does it include inherited stocks/bonds/cash? Does an unlimited exemption apply to assets inherited by children, relatives, or non-relatives, or only to those inherited by spouses? – DH via email

A: My statement wasn’t based on confidence about what a new bill will include. It’s based on a tax law that’s already on the books.

Just to be clear about this, your question involves two entirely different taxes. One is the federal estate tax -- also known as the inheritance tax – which expired at the end of 2009. As you say, there is no federal inheritance tax this year.

The other is the capital gains tax on inherited assets. This is not the same tax as the inheritance tax.

For many years, the Internal Revenue Code has said that with few exceptions, assets that are part of your taxable estate pass to your heirs – to all your heirs, regardless of their relationship to you – at their market value on the date of your death.

Your taxable estate is everything you own when you die, even if it isn't big enough to incur an inheritance tax. In other words, the unlimited capital gains tax exemption applied to every estate.

The result: Your heirs could sell inherited assets -- including houses, stocks, bonds, bank accounts, stamp collections, and diamonds -- for a price equal to their market value at the time of your death without owing any capital gains tax. (The exemption doesn’t include assets on which you would have owed ordinary income taxes if you’d lived: Your heirs owe taxes on withdrawals from your retirement accounts, just as you would.) 

If your father owned a house that he bought for $20,000 and he sold it for $250,000, he would owe a capital gains tax on a $230,000 profit. However, if he left you that house in his will, you’d inherit it at its ‘stepped-up’ $250,000 value. You could sell it for $250,000 without incurring any tax.

But as you may have noticed (since I italicized it) this unlimited capital gains tax exemption in the Internal Revenue Code applies to the assets that are part of your taxable estate.

This year, nobody has a taxable estate because there's no federal estate tax. Therefore, no one gets an unlimited capital gains exemption. If you die in 2010, there's a capital gains exemption on only up to $3 million of the appreciated assets that you leave to your spouse, and only on up to $1.3 million of assets you leave to everybody else.

The unlimited exemption is still in the Internal Revenue Code, however. It will apply again as soon as estates are subject to federal estate tax. That will be in 2011, even if Congress doesn’t pass a new estate tax law. In the absence of a new law, we will revert to the law that existed before the last one expired. That law imposes federal estate tax on estates worth more than $1 million. 

Please send your questions to Lynn@LynnBrennersFamilyFinance.com.  I'm sorry I can't respond personally to every email. Questions are only addressed online.

 (c:) Lynn Brenner, All Rights Reserve