Question

You understand that the built-in gain on inherited property escapes taxation in almost all cases because (i) relatively few Americans die with estates large enough to attract the federal estate tax and (ii) beneficiaries receive inherited property with a FMV basis (not to mention the minor detail that inherited property is automatically long-term). What is your view of this specific aspect of the federal income tax system – i.e., the treatment of inherited property?

Answer 1

On the surface, the U.S. estate tax system looks quite complicated. There are 12 different estate tax brackets with rates ranging from 18% to 40%. Taxable estates ranging from $0 to $10,000 are taxed at an 18% rate, and on the higher end, the amount of taxable assets that exceeds $1 million is taxed at a 40% rate.

For real estate purposes, it’s also important to note that this includes money and property. As a simplified example, if someone leaves $10 million in cash and $5 million worth of real estate to heirs, it would be considered a $15 million estate. Real estate is valued based on the fair market value at the time of the decedent’s death.

The estate tax may sound complex and expensive, but it’s important to realize that it only applies to wealthy households. Most Americans don’t have to worry about it. Specifically, all Americans are allowed to exclude a certain amount of assets from their taxable estate, known as the lifetime exemption. This amount is adjusted for inflation over time and is $11.58 million per person for 2020.

Note that this is a per person figure. Married couples can exclude twice this amount, or $23.16 million. If your spouse dies before you do and leaves you their assets, you can use both exemptions when leaving your estate to your heirs.

Technically, this is structured as a tax credit. Estate tax is calculated on all of your assets when you die, and there’s a nonrefundable credit equal to the tax that would be charged on the lifetime exemption ($4,577,800 in 2020).

This may sound complicated, but the end result is actually quite simple: Any assets left to your heirs will be taxed at a 0% rate up to $11.58 million and at a 40% rate beyond that amount. In other words, if you die with $20 million in assets that you leave to heirs, your calculated estate tax would be 40% of the $8.42 million that is in excess of your lifetime exclusion, or $3,368,000.s

It's also important to point out that estate taxes aren’t paid by people who inherit the property. Rather, any estate taxes due are paid directly by the estate before it is distributed to heirs. And if there aren’t enough liquid assets to pay the estate taxes due, property can be sold to pay the estate’s tax bill.