Capital Gains Tax On Inherited Property

We got this question from one of our readers:

“My wife received about 160 acres when her mother passed away 3 years ago in a trust, which came from her grandfather who left it to her mom in trust.  We were told that we will have to pay capital gains tax on what the value of land was back when her grandfather passed away in 1979.  I found the land was valued at $559 an acre then and she sold it in 2012 for $9000.00 an acre.  Is this true and what will we be paying in capital gain tax’s?”

This was not quite the verbatim question (I changed some of the facts to make it more general for purposes of this post and edited some of the sentence structure), but this answer will most likely apply to 1,000s of farm families in 2012 since many sold their inherited land to escape the higher 2013 capital gains tax rates.

Since the land was left to her mother in trust, the value to be used for capital gains tax purposes is based upon the value when the grandfather passed away.  This trust was most likely set up as a “Grandfather” skipping trust and that is why the land did not get a step up in basis when the mother passed away 3 years ago.  These trusts are designed to skip a generation (or more) and not have to pay any estate tax when the mother passes away, however, the potential drawback is that the land does not get stepped up in value when mom passed away.

Therefore, the total gain is about 160 acres times $8,441 per acre or about $1.35 million.  Inherited property always qualifies for long-term capital gains treatment (even held for less than a year) and therefore, the maximum federal tax is 15% or about $203,000.  If the taxpayer’s state imposes an income tax, then that rate would be applied to the same gain.  Let’s assume that rate is 9%, then the state income tax would be about $122,000 in state taxes for total combined taxes of $325,000.

If the taxpayers had waited until 2013 to sell the land, their state tax would be the same, but their federal tax rate would be about 25% on most of it or an extra $135,000 of tax.

Paul Neiffer, CPA