Determining the Tax Basis of a Decedent’s Home

Most people’s estates are too small to be charged estate tax. According to the IRS, in 2021, only estates worth over $11.7 million are liable for estate taxes. Many states don’t have an estate tax or inheritance tax for homes or any other assets of a decedent, regardless of their value. However, when estate or inheritance taxes do apply, the value of the home at the time of death is the core consideration as to whether the home’s value will be taxed by either estate tax or state inheritance taxes. The final tax rate may be based on how much the asset is worth and the inheritor’s relationship to the decedent. When calculating the value of the asset, appraisers use what is known as the cost basis.

Understanding Cost Basis and its Use in Tax Rate

A cost basis method for estate tax is different from when it’s used for other tax purposes. Cost basis can represent, for example, the original value of an asset when it comes to the capital gains tax due on the sale of the asset. If a client inherits an asset, then the cost basis of that asset from the inheritor’s standpoint is its fair market value (FMV) either at the time of the deceased person’s death or when the transfer of assets was made to the inheritor.

FMV is the price that an asset would sell for on the open market, all other things being equal. The cost basis for the estate tax assumes that both buyers and sellers know that the asset is up for sale. It also considers that a reasonable time would have elapsed for an offer to be made. That offer would reference the open market value for the property.

The appraiser will establish the cost basis of the property on the valuation date. If the value of the asset has dropped significantly since the previous owner’s death or the date of transfer, the appraiser may opt to use a different date for the appraisal, as long as it falls within six months after the date of the original owner’s death. Delaying the appraisal might defer some of the tax due on the inheritance if the value of the asset drops. It’s important to note that under Internal Revenue Code 1014, the inheritor of an asset will get a step up in the basis of the asset when estate taxes are due and also when no estate taxes are due.

Choosing a Valuation Date

Choosing an alternative valuation date may present a few potential disadvantages. The timing of the valuation doesn’t apply only to the decedent’s house, but also to all assets within the decedent’s estate. Additionally, if the appraised value is low, the inheritor may save on inheritance taxes, but it will cost more when the asset is eventually sold. The appraised value will be used for calculating future capital gains taxes. As a result, any appreciation that adds to the house’s value or the value of other estate assets will be taxed based on the difference between their market value and the initial valuation for inheritance.

Capital Gains on Sold Assets

Selling inherited assets instead of transferring them to heirs might seem like a way to avoid inheritance taxes, but it isn’t. The estate as a seller will still have to pay taxes on the inheritance. If it’s sold at a price above the valuation, the estate will also be required to pay capital gains tax on the difference. However, if the asset is sold at fair market value, the more quickly it’s sold, the lower the capital gains tax to be paid. There is a peculiar clause for inherited property: If someone holds onto a property for only one day and then sells it, the inherited property is considered to have been held for no less than one year. Capital gains or losses can be regarded as long-term gains or losses for taxation. If someone sells inherited property immediately, they avoid getting hit with a higher tax rate reserved for individuals who hold onto those properties.

Inheritance Tax Exemptions

If someone lives in a state that taxes inheritances, the state usually waives taxes on small inheritances or when a family member is the inheritor. Pennsylvania, New Jersey, Maryland, Nebraska, Iowa and Kentucky still leverage tax on inherited estates. However, none of these states requires spouses to pay taxes on their inheritance. The dollar-value at which inheritance taxes kick in and how the decedent was related to the inheritor affects the rate. The dollar-value threshold may vary anywhere from $500 to $40,000. Tax rates are also wildly different, ranging from one percent to 18 percent on inherited estates.

Unfortunately, there’s no overarching guideline that covers all the states that charge inheritance taxes. Each state has its own rates and rules. Being familiar with each state’s rates can help ease the burden of uncertainty. Currently, the rates for the states that impose estate taxes are as follows:

Iowa: Inheritance tax can be up to 15 percent on the value of the inherited estate.

Kentucky: Individuals who inherit property may pay up to 16 percent on the value of the estate.

Maryland: Tax rates on inheritance may range from zero percent up to 10 percent on the value of the property.

Nebraska: Inheritance taxes top out at 18 percent on the value of the inherited property.

Pennsylvania: Taxes reach as high as 15 percent.

New Jersey: Tax rates can range to 16 percent on some inheritances.

As a rule of thumb, the more closely blood related an individual is to the deceased, the lower the value of the tax they are required to pay on their inheritance.

Not All Death Taxes Are the Same

Both estate taxes and inheritance taxes are colloquially referred to as “death taxes.” However, on their own, each of these taxes serves different purposes. Inheritance taxes are charged on the value of an inheritance. This consideration includes property and non-real-estate assets, even money transferred to the beneficiary. On the other hand, estate taxes are levied on the size of a deceased person’s estate. In states where both inheritance and estate taxes apply, a beneficiary can end up being taxed twice on the same asset.

While no one likes being reminded of their mortality, knowing how to deal with inheritance taxes is crucial to intelligent estate planning. Putting assets into dynasty trusts or transferring them before death may help to sidestep inheritance and estate taxes. Understanding your options as well as the pros and cons can help frame your decision.