While beneficiaries generally do not have to pay income tax on assets they inherit, if they sell the assets after inheriting them they may have to pay a capital gains tax. The capital gains tax is premised on the concept of “tax basis.” The tax basis of an asset is the value that is used to calculate the taxable gain or loss when the asset is sold. Generally, the tax basis is the price the owner paid for the asset. However, this doesn’t work when the owner inherited the asset rather than buying it. In cases of inheritance, the tax basis is the asset’s value at the time of the former owner’s death. This is known as a “stepped-up basis”, since the basis has increased from the previous owner’s purchase price to whatever the value is when he or she dies.
The right estate planning strategies can go a long way towards reducing capital gains taxes. For example, consider undoing a trust. Assets that were gifted into trust are not part of an estate, but putting them back into the estate could avoid capital gains taxes.
You can also look into what is known as “upstream giving.” This is where an asset is transferred up to an older family member (such as a parent), or to a trust that was setup for the benefit of an older family member. The result is that the asset achieves a step-up in basis at the time of the older family member’s death. The asset would then revert back to the original family member who made the gift, or their descendants. The asset could then be sold free of capital gains tax provided that the older family member survived the original transfer by at least one year.
If you are dealing with highly appreciated assets, a Joint-Exempt Step-Up Trust (JEST) might be a good option. This type of trust lets a surviving spouse sell an appreciated asset free of capital gains tax after the death of the first spouse. In effect, the JEST provides the benefit of a step-up in basis to current market value upon the passing of the first spouse, so the surviving spouse can sell the appreciated asset without owing any capital gains tax.