Although a death in the family can be tragic, it leaves the opportunity for the survivors to share in the decedent's legacy through inheritance of assets. Unfortunately, the process of inheriting an asset is fraught with tax considerations and tradeoffs. Having a good tax attorney and CPA can help to both streamline the process and minimize tax liability.
Property that is passed through probate is subject to two types of taxes--estate tax and, when it is sold, capital gains tax. Determining how much tax is to be owed requires an understanding of the property's fair market value at the time of the decedent's passing. This fair market value is typically set by a professional appraisal of the property.
As of the 2011 tax year, federal estate taxes were a flat 35 percent, with a $5,000,000 exclusion. For an estate containing just one piece of land worth $7,000,000, the estate tax would be $700,000, which is 35 percent of $2,000,000 -- the value in excess of the exclusion amount. If the total value of the estate, including the land, were worth $4,000,000, there would be no estate tax due. Estate taxes have changed repeatedly in the past and may change again in the 2012 tax year or later.
Capital Gains Taxes
When a property transfers via inheritance, its tax basis gets reset for valuation purposes to the fair market value at the time of transfer. If you sell the property for that value, there is no gain. If you sell it for more than the value, though, you will be subject to capital gains taxes, which, as of the 2011 tax year, were 15 percent of the gain.
Valuing a property to establish its basis is a tightrope walk. Setting the value high can minimize future capital gains taxes but can lead to increased liability for estate tax, especially with larger estates. Conversely, setting the value low can reduce estate tax, but increase the likelihood that you will pay capital gains tax. Generally speaking, with a piece of land that is not large enough to be subject to estate tax, it is better to err on the high side and minimize capital gains liability, and with a piece of land that is subject to estate tax, erring on the low side will minimize estate tax liability at the cost of having to pay more at the lower capital gains rate. In either case, your valuation should be as accurate as possible, since the IRS could disallow your valuation at some future date otherwise.
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