In this video, we walk through 5 REG practice questions demonstrating how to calculate capital gains from the sale of inherited assets to be included in an individual’s gross income. These questions are from REG content area 4 on the AICPA CPA exam blueprints: Federal Taxation of Individuals.
The best way to use this video is to pause each time we get to a new question in the video, and then make your own attempt at the question before watching us go through it.
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How to Calculate Capital Gains from the Sale of Inherited Assets
1. Determine the Basis of the Inherited Asset
For assets received from a decedent, the basis is generally the fair market value (FMV) of the asset at the decedent’s date of death (known as “step-up” or “step-down” in basis). If an alternative valuation date is used (six months after the date of death), the FMV on that date becomes the basis. This step-up or step-down in basis can significantly affect the capital gain or loss realized upon the sale of the asset.
2. Calculate the Adjusted Basis
The adjusted basis is the basis of the asset adjusted for any improvements made to the asset, depreciation taken, or other relevant adjustments. For inherited assets, the adjusted basis usually starts with the FMV at the date of death (or the alternative valuation date) and is adjusted from that point forward.
3. Determine the Sale Price of the Asset
This is the amount you sold the asset for, minus any expenses associated with the sale (like commissions or fees).
4. Calculate Capital Gain or Loss
The capital gain or loss is the difference between the sale price of the asset and its adjusted basis. If the sale price is higher than the adjusted basis, you have a capital gain. If the sale price is lower, you have a capital loss.
5. Determine the Holding Period
For inherited assets, the holding period is automatically considered long-term regardless of how long the decedent or the inheritor actually held the asset.
6. Apply Capital Loss Limitations
If the sale of assets results in a capital loss, the IRS allows individuals to use these losses to offset capital gains. If capital losses exceed capital gains, individuals can use the loss to offset up to $3,000 ($1,500 if married filing separately) of other income per year. If total net capital loss is more than the limit they can deduct, they can carry over the unused part to the next year and treat it as if they incurred it in that next year.
Special Considerations for Inherited Assets:
For inherited assets, the $3,000 capital loss limit to ordinary income applies similarly as it does to assets not received as part of a decedent’s estate. The key difference in handling inherited assets lies in determining the basis and the fact that all gains are considered long-term, which can affect the tax rate applied to the gain.
Example:
Sarah inherited a stock portfolio from her uncle, who passed away on June 1, Year 1. The fair market value (FMV) of the portfolio at her uncle’s date of death was $50,000. Sarah sold the portfolio on July 15, Year 2, for $60,000. There were no significant adjustments to the basis, such as improvements or depreciation.
Step-by-Step Calculation:
- Determine the Basis of the Inherited Asset:
- The basis of the inherited stock portfolio is its FMV at the date of the decedent’s death, which is $50,000.
- Calculate the Adjusted Basis:
- Since there were no adjustments to be made, the adjusted basis remains $50,000.
- Determine the Sale Price of the Asset:
- The sale price of the portfolio was $60,000.
- Calculate Capital Gain or Loss:
- The capital gain is the difference between the sale price and the adjusted basis: $60,000 – $50,000 = $10,000.
- Determine the Holding Period:
- Since Sarah inherited the asset, the holding period is automatically considered long-term, regardless of how long she actually held the asset before selling it.
- Apply Capital Loss Limitations:
- In this scenario, Sarah realized a capital gain, not a loss, so the $3,000 capital loss limit does not apply. However, if Sarah had a total net loss for the year from other investments, she could use up to $3,000 of that loss to offset other income, such as wages or salaries, with any remaining loss carried over to future years.
