Generally, when you sell an asset, its appreciation in value from the time you acquired it is a “capital gain” on which you must pay federal and state income tax. Conversely, if the asset’s value at the time it is sold is less than what it cost to buy, the owner realizes a “capital loss” that often generates an income tax deduction. This rule applies to “capital assets.”
What are Capital Assets?
Capital assets include the following:
- real estate
- personal property
- brokerage accounts
- stocks
- bonds
- bank accounts
- businesses
- art
- antiques
- collectibles
Assets that are NOT considered “capital assets” include:
- IRAs
- employer-sponsored retirement plans
- 401(k)s
- pensions
- tax-deferred annuities
- gifts made before death
- and some other assets
Stepped-Up Basis
A special capital gains/loss rule, referred to as “stepped-up basis,” applies to persons who inherit capital assets: Persons who inherit capital assets and thereafter dispose of those assets do NOT pay income tax on the appreciation in value.
EXAMPLE: John bought a home years ago for $100,000 and it’s worth $250,000 when he dies. When his children, who inherit the home, thereafter sell it, they owe no income tax on the $150,000 of appreciation that accrued from the time John bought the home to the date of his death. John’s “basis”, that is, his cost in acquiring the home, is “stepped-up” to the home’s value as of the date he died. But, if before John died, John gifted the home to his children, John’s basis would have carried over to his children. The full amount of appreciation would be taxable to the children. That is referred to as “carry-over basis.”
For capital assets that are co-owned, generally, the share of a co-owner that dies is stepped up to its value on the date of death. The new tax basis passes on to each surviving co-owner in proportion to the survivor’s ownership interest.
Obviously, less income tax – often a lot less – is owed if someone inherits appreciated assets from a loved one rather than acquiring them by gift before death. But what if the owner of the appreciated assets requires long-term care and must liquidate and spend down those assets to pay for that care? nothing is left at time of death? No tax because nothing is left to inherit. Fortunately, with proper planning, highly appreciated assets can be saved and passed along to loved ones in a way that preserves for them a stepped-up basis, thus avoiding the payment of income taxes. Those measures include, most notably, a properly structured Medicaid Asset Protection Trust.
Contact the lawyers at Vasiliadis Pappas if you would like to learn more.
