A Capital Gains Tax Mistake (Part 2)

In my blog post last week I told you about a call I received from a client facing an unexpectedly large income tax bill.  The increased tax resulted from real estate that he inherited from his parents – or so he thought.  An inheritance is what one receives from someone as a result of their death.  In actuality, the real estate he received was not an inheritance but rather a gift given to him by his mother after his father died.

At first glance, this may seem to be only a matter of semantics.  The client received the property from his parents.  What does it matter whether it was an inheritance or a gift made by the donor while she was alive?  Because how the transfer occurred impacts capital gains tax in a big way.

Capital gains tax is paid when a particular asset is sold by the owner for an amount that is more than what he purchased the it for.  Most common assets that can result in capital gains are stocks, bonds, mutual funds and real estate.  As these assets increase in value, there is resulting capital gains – the difference between the current value and what it was purchased for, what is referred to as the asset’s “basis”.  The gain is referred to as “unrealized gain” while the owner continues to hold the asset.  It only becomes taxable when the owner sells the asset.  (If the asset is sold for less than the purchase price that is known as a capital loss.)

Capital gains must be reflected on the taxpayer’s income tax return for the year that the asset sale took place.  Any tax is then paid as part of the taxpayer’s overall tax liability for the year, which is due on April 15 of the next year.  (A capital loss can be used to reduce overall tax liability.)

There is, however, an exception to this method of calculating capital gains – what is known as a “stepped up basis”.  Next week I’ll share with you more about this and how it could have helped our caller.