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New capital gains rules
for inherited property

Thinking about selling that stock you inherited from Aunt Edna, but haven't because you think you'll have to pay outrageous capital gains taxes? Certain types of property receive special treatment under the capital gain rules prescribed by the Taxpayer Relief Act of 1997. The good news was that taxpayers who sold inherited property were entitled to lower tax rates on all gains. The bad news was that the property had to be held for more than 18 months to be eligible for the lower tax rates.

The good news for 1998 is that you don't have to hold property for more than 18 months to be eligible for the lowest capital gains rates. As this tax tip explains, in most cases you only have to hold property more than one year to be eligible for the 10 percent or 20 percent tax rate. After explaining how changes in the tax rules have eliminated the midterm gain, this tax tip explains how to qualify for the lower tax rates. Examples then compare the capital gains taxes for property held and sold by the same owner to those on property passed on to an heir.

In addition, you will learn that sellers of inherited property receive a "stepped-up basis" for computing the gain. How does this help you if you have sold inherited property? As this tax tip demonstrates, your basis is the property's fair market value (FMV) as of the date of death of the deceased, instead of the FMV on the date it was actually purchased.

Midterm capital gains tax eliminated

Capital gain

Length of time item was held

Tax rate applied to gain

Short-term capital gain

One year or less

Same income tax rate as ordinary income

Long-term capital gain

More than one year

10% for taxpayers in the 15 percent income tax bracket; 20% percent for other brackets.

As discussed in previous tax tips, new tax legislation has decreased the tax rates on long-term capital gains. Last year introduced a new tax category, the mid-term capital gains tax.

This applied to property held more than one year and 18 months or less. The addition changed the definition of long-term from more than one year to more than 18 months. However, legislation applying to this year has eliminated the midterm capital gain.

How does this affect the tax treatment of inherited property? Last year's midterm capital gain complicated tax matters for inheritors. In order for inherited property to still automatically receive this new lower tax rate, its automatic holding period had to be changed to more than 18 months. This holding period is now more than one year.

Fortunately, none of these confusing changes have altered the definition of the basis. It remains the property's fair market value on the date of the death.

Pass through to heirs decreases tax
The following table and example illustrate the advantages of these inherited property provisions:

Stock Acquired
(date)

Stock sold
(date)

Capital gain

Tax paid
(capital gain x income tax rate)

$10,000
(May 1, 1998)

$15,000
(Dec. 1, 1998)

$5,000

$5,000 x 28% = $1,400

A single taxpayer acquires 100 shares of stock for $10,000 on May 1, 1998. She sells all 100 shares for $15,000 on Dec. 1, 1998. Her capital gain of $5,000 ($15,000-$10,000) will be treated as a short-term gain, since she held the stock for less than one year. Short-term capital gains are taxed the same as ordinary income. If she is in the 28 percent income tax bracket, her income tax on this gain is $1,400 ($5,000 x 28%).

Now assume she didn't sell the stock. She dies on Dec. 20, 1998. Her sole heir inherits this stock. The fair market value of the stock on Dec. 20, 1998, was $15,000. The heir then sells the stock for $17,500 on Dec. 26, 1999. Her gain on the sale is only $2,500 ($17,500- $15,000). Assume the heir is also in the 28 percent income tax bracket. Based on the new rules, she pays 20 percent tax on this gain. Her tax is only $500 ($2,500 x 20%).

Fair market value at death
(date)

Stock sold
(date)

Capital gain

Tax paid
(capital gain x income tax rate)

$15,000
(Dec. 20, 1998)

$17,500
(Dec. 26, 1999)

$2,500

$2,500 x 20% = $500

Inherited collectibles are still collectibles
These inherited property provisions would seem to be a solution to the exclusion from the new capital gain rules discussed in a previous story on "collectibles."

It would seem that taxpayers could avoid the collectibles sales exception by passing these items to their heirs, who would enjoy automatic long-term capital gains treatment upon selling them.

Unfortunately, this isn't an acceptable strategy. The inherited property provision specifically prohibits this automatic long-term status for inherited collectibles. Instead, they are treated as regular collectibles. The old tax rules apply to these capital gains. The seller doesn't use the new long-term capital gain rates. However, he can lower his gain by claiming the higher "stepped up basis."

Conclusion
The Taxpayer Relief Act of 1997 included provisions that assisted and frustrated taxpayers who had inherited properties. They were entitled to lower tax rates on gains resulting from selling these properties. However, they had to hold the property for more than 18 months to be eligible for the lower tax rates.

The good news for 1998 is the elimination of 18-month holding period for the lowest capital gains rates. Beginning in 1998, you don't have to hold property for more than 18 months to be eligible for the lowest capital gains rates. Now, in most cases, you only have to hold property more than one year to be eligible for the 10 percent or 20 percent tax rate.

In addition, the seller receives a "stepped-up basis" for computing the gain. How does this help you if you have sold inherited property? You are allowed to consider the basis to be the property's fair market value as of the date of death, instead of its price on the date it was actually purchased.

 

--Nov. 1, 1999

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