Family heirlooms can have both sentimental and monetary value, and the heirs who receive them might care more about the cash those keepsakes are worth than the family history they represent.
But when it comes time to put a price on a priceless family treasure — or any asset that gained value over time — the IRS might tax the difference between what you paid for it and what you sold it for. But with the right strategy, you can shrink that difference to zero, no matter how much you earn from the sale.
“Timing is everything,” said Whitney Sorrell, CPA, tax attorney, former IRS agent and founder of Sorrell Law Firm. “One road brings a big tax liability. The other leads to a tax-free sale.”
Was It Given as a Gift or Willed as an Inheritance?
When calculating capital gains taxes, the IRS treats assets handed down as an inheritance after death much differently than assets gifted while the owner is still alive, regardless of whether it’s art, coins, a mansion or a classic car.
“The secret is that when parents wait to give property to their beneficiaries upon their death, the property can be sold by the beneficiaries without any tax liabilities,” said Sorrell. “Here is how it works. When parents give appreciated property during their lifetime, the parents’ cost basis carries over to the child. This is called the carryover basis rule.
“But if the parent gifts the same property at death, the child takes a cost basis equal to its fair market value at the date of death, thanks to Internal Revenue Code Section 1014. This is called the stepped-up basis rule.”
Essentially, capital gains taxes apply to the difference between what you paid for an appreciating asset and what you sell it for. But if you bequeath it after death, your heir inherits the heirloom but isn’t responsible for the value it gained under the parent’s ownership. The asset starts fresh with an updated cost basis and starts appreciating from zero all over again.
Sorrell offered a real-world example to illustrate how important it is to leave heirlooms — or any assets, for that matter — upon your death instead of gifting them to heirs while you’re still alive.
“If you buy a painting for $10,000 and then sell it for $25,000 the IRS taxes the capital gain of $15,000,” he said. “If the parent gives the painting to a child while living, then the child takes a carryover basis of $10,000 and pays tax on the $15,000 gain when the child sells the property. However, if the parent gifts the property to the child at death, the child takes a cost basis equal to the fair market value at death — $25,000 in this example — and thus there is no taxable gain when the property is sold, thanks to the stepped-up basis rule.”
If the child keeps the painting for a few years and then sells it after it further appreciates to $30,000, then he or she will pay tax on a gain of only $5,000 instead of $20,000.
Although the stepped-up basis rule covers all kinds of property, many people pay taxes they could have avoided if the original owner had known more about transferring ownership of assets.
“This rule is so easily beneficial to families gifting property to descendants and so often forgotten, resulting in unnecessary taxes paid by the kids,” said Sorrell. “And, the stepped-up basis rule applies to all assets, including the value of the family business, real estate and investment portfolios. It is always more tax efficient to gift appreciated assets to beneficiaries at death, and not during life.”
But each situation is unique — and stepped-up basis is just one of many rules that govern the complex and high-stakes world of estate planning. The best way to avoid unnecessary tax burdens for you or your heirs is to invest in professional help.
“Consulting with a tax professional or an estate planning attorney can provide valuable guidance specific to your situation,” said estate planning and probate attorney Celeste Robertson, owner of The Law Offices of Celeste Robertson. “They can help you navigate the tax implications, identify potential deductions or exemptions and ensure compliance with tax laws.”
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