As an estate planning and probate attorney, I am often involved in the sale of real estate that my clients inherited and have to deal with a very important question: “will my client have to pay capital gains tax on the sale”? As a brief introduction, capital gains tax is the government’s way of taxing people when they sell property for more than they bought it. The IRS, New York City, and New York State will tax the “capital gain” which can amount to more than 35% of the gain.
For example, if John bought an investment property for $100,000 in 2010 and sells it for $350,000 in January 2015 (the fair market value at the time), will have to pay capital gains tax on the $250,000 gain. But what if, instead of selling the investment property, John dies in January 2015, his son Jimmy inherits the property and sells it for $400,000 in 2017 – what is Jimmy’s taxable gain? Is it $300,000 (the difference between what Jon paid and the sales price in 2017) or $50,000 (the difference between the date of death fair market value and the sales price)? In my experience, many people tend to think the answer is $300,000 but the good news for beneficiaries is that inherited property (whether through a will, intestacy, or through many types of trusts) gets a step-up in basis when the decedent dies. In our second scenario, Jimmy would have a taxable gain of only $50,000 when he sells the property.
A more common example, and one I deal with frequently, is where mom dies owning a $1.2 million home which she bought in 1972 for $10,000 (remember when homes in NYC cost that little? Me neither). The son wants to sell the house immediately after mom’s passing. How much capital gains tax would he owe? Likely very little to none. What would mom pay if she sold the house while she were alive? Over $420,000!
The reason for this result is that the tax code (IRC 1014) states that the tax basis of a property passing to a beneficiary is the fair market value at the date of the decedents death (with some exceptions). In addition, expenses related to the sale of the real estate such as transfer taxes, broker’s commissions, and legal fees further increase the tax basis. And since the tax basis is the starting point for determining capital gains tax, it stands to reason that most real estate sales that occur shortly after death will not incur a capital gains tax. As an example, if dad died and left a $250,000 property to son who then sold it a year later for $270,000, the son would have a $20,000 capital gain. However, if the son had to pay a broker $15,000 to market and sell the property and an additional $10,000 in real estate transfer taxes, any gain would be wiped out and no capital gains tax would be due, even though the property sold for more than fair market value at death. If, however, the beneficiaries wait a while to sell the real estate, or the market for the particular property changes quickly, a capital gains tax may be due.
What if, instead of waiting until death, a parent decides to be generous and gift their children their real estate while they are still alive? As my prior article on gifting the home to children illustrates, it is a bad idea for many reasons, not the least of which is that the gift causes the child to take the parent’s tax basis. That means that if mom gifts her home to her son shortly before she dies, instead of leaving it to him in a will or trust, and the son sells the home, he may have to pay over $420,000 in taxes. Who says patience doesn’t pay?
It is important that an experienced estate attorney, working in conjunction with an estate accountant, reviews the exact situation with the client and makes recommendations in order to minimize taxes, including estate tax, income tax, and capital gains tax.