Who Pays Capital Gains Tax on a Deceased Estate?

When a person passes away, their estate may include various assets that could be subject to capital gains tax. Understanding who is responsible for these taxes is crucial for executors and beneficiaries, as it impacts the distribution of the deceased’s assets.

This article examines key aspects of capital gains tax on a deceased estate, focusing on how different parties are affected by tax obligations and the necessary steps during this process.

The Step-Up in Basis

The step-up in basis is a tax provision that adjusts the cost basis of a deceased person’s assets to their fair market value at the time of death. This adjustment reduces the capital gains tax burden for beneficiaries inheriting these assets. For example, if a decedent purchased property for $100,000 and its value increased to $300,000 at the time of death, the basis for heirs is adjusted to $300,000. If they sell the property for $300,000, no capital gains tax is incurred, as there is no gain from the stepped-up basis.

This provision is particularly advantageous for appreciated assets such as real estate, stocks, or other investments, as it allows heirs to avoid significant capital gains taxes that would apply if the original purchase price was used. The step-up in basis is governed by the Internal Revenue Code Section 1014, which outlines the conditions for this adjustment. Executors and beneficiaries should familiarize themselves with these rules to ensure compliance and optimize tax outcomes.

Executor’s Reporting Requirements

Executors are responsible for managing and distributing the estate’s assets while adhering to tax obligations. One key duty is filing the decedent’s final income tax return, covering the period from the start of the year until the date of death. This must be filed by the standard tax deadline, typically April 15 of the following year, unless an extension is granted.

If the estate generates more than $600 in annual gross income—such as dividends, interest, or rental income—the executor must file an estate income tax return (Form 1041). Estates are taxed at rates different from individual ones, and any taxes owed must be paid from the estate’s funds.

For estates exceeding the federal estate tax exemption of $12.92 million in 2024, the executor must file Form 706, due nine months after the decedent’s death, with an optional six-month extension. Executors should also consider state estate taxes, as some states impose their own taxes with varying exemption thresholds.

Beneficiaries’ Tax Obligations

Beneficiaries inheriting assets may face tax obligations despite the step-up in basis. Income generated by inherited assets, such as dividends, interest, or rental income, is subject to regular income tax and must be reported on the beneficiary’s personal tax return, with rates based on their overall income bracket.

In some states, beneficiaries may also encounter inheritance taxes. Unlike federal estate taxes, inheritance taxes are levied on recipients rather than the estate itself. As of 2024, only a few states, including Iowa and Kentucky, impose inheritance taxes, with varying rates and exemptions. Beneficiaries inheriting from estates in these states must comply with local regulations to avoid penalties.

Trusts established as part of an estate plan can also affect beneficiaries’ tax responsibilities. Trust distributions may carry taxable income, requiring beneficiaries to report it on their individual tax returns. Whether distributions consist of income or principal determines the tax treatment, with income typically taxable and principal not. Beneficiaries should review trust documents and consult tax professionals to understand their obligations fully.

Filing Deadlines and Distribution Scenarios

The timing of asset distribution plays a key role in tax outcomes. Executors must balance timely distribution with potential tax consequences. Distributing assets before filing the estate tax return could trigger penalties if taxes are owed, while delaying distribution may increase administration expenses, reducing the inheritance.

Strategic timing of asset sales can also minimize tax liabilities. Selling appreciated assets shortly after the decedent’s death can capitalize on the stepped-up basis and reduce capital gains taxes. Conversely, holding onto assets during market volatility might allow beneficiaries to benefit from future appreciation. Decisions on timing should consider market trends, tax implications, and beneficiaries’ financial goals.