A Capital Gains Tax Mistake (Part 3)

In my blog post last week, I was explaining the large and unexpected capital gains tax a client faced.  I explained that capital gains is paid on an asset that has appreciated when it is sold.  In my client’s case, he had sold real estate that his mother had given him after his father died.  When he filed his income tax return for the year he sold it, his CPA told him he had a large six figure tax to pay.  

The amount surprised him but that’s because no one explained to him (or his mom) before the transfer how capital gains tax works.  Had they gotten that advice, they could have avoided or minimized the tax.

What they missed was something called a stepped up basis.  As I wrote last week, normally the capital gains is taxed on the difference between the sale price and the basis, which is the purchase price.  (In the case of real estate, capital improvements made during the course of ownership can raise that basis.) 

Had the property been inherited by my client, rather than gifted by his mother during her lifetime, he would have received a stepped up basis to the value of the property when his mother died.  This “reset” basis could have eliminated or drastically reduced his tax bill depending on when he sold it.  If the sale occurred immediately after her passing, the new basis would have been the sale price.  The capital gains would have been zero and of course no capital gains tax.

On the other hand, if he had decided to hold onto the property and then sell it years later, he would have had to pay capital gains tax on the appreciation in value from the date of his mother’s death.  He would, however, have avoided the appreciation from the time she purchased the property many years earlier.  I should note that the property did get a stepped up basis for Dad’s half to the value at the time he died and Mom then inherited that half.  Had they received guidance, however, the result could have been so much better.