When someone sells an asset, they pay tax on the difference between the selling price and the adjusted basis (original cost plus improvements minus depreciation) of the asset--capital gains. The basis is determined when the asset was acquired.
In the case of inherited property the basis is not what the decedent initially paid for the asset. It is "stepped up" to the fair market value of the asset on the date of the decedent's death. This stepped-up basis applies to all inherited assets, including stocks, bonds, and real property. It can enable a beneficiary to minimize their tax liability when selling an inherited asset.
Here's an example. A home owner makes a provision in his Will to give his house to his daughter after he dies. He paid $100,000 for it 30 years ago. After he passes away his daughter inherits the house, but she doesn't plan to live in it and she sells it for $350,000. Ordinarily, she would be liable for capital gains taxes on $250,000 profit ($350k-$100k) without the stepped-up basis. Currently, the tax rate on that profit can be up to 20% for federal and up to 9.85% for Minnesota, depending on other income.
However, with the
stepped-up basis, the daughter would only be liable for taxes on the difference between
the sale price and value at the time of her father's death. So if the property
had a fair market value of $325,000 at the time of his death and she later sold it
for $350,000, she is only responsible for tax on $25,000 in profits.
If the sales price of
an asset is less than the basis, she could claim a capital loss.
Note that capital gains are either short-term or long-term. If a beneficiary sells the house within a year of taking ownership, this is considered a short-term gain and it is taxed as ordinary income. But there is a "home sales tax exclusion" rule that could protect the beneficiary from much of the capital gains tax liability. If the beneficiary inherits real property and lives in it as the primary residence for at least two years before selling it, the beneficiary can realize up to $250,000 in capital gains without paying taxes if single ($500,000 of gains if filing jointly).
Giving valuable property to your loved ones can create some issues for them when they inherit. Talking to a qualified attorney or tax advisor is a good idea when you are planning how best to distribute your assets.