After an estate asset is approved by the local probate court to be distributed to estate beneficiaries, the asset’s cost basis becomes the fair market value on the date of death (a step-up in basis). This change of value in the estate asset helps estate beneficiaries reduce their individual income taxes when they decide to sell the former estate asset. When selling any asset, the capital gain tax is calculated by first subtracting the cost basis from the sale price.
Example 1 [sale before death]:
1997: Uncle John bought Amazon stock at $20
2021: Uncle John sold his Amazon stock at $170,
2021: Uncle John reports capital gains of $150 ($170-$20).
Example 2 [sale after death]:
1997: Uncle John bought Amazon stock at $20
2022: Uncle John died with Amazon stock at $120
2022: Uncle John's estate beneficiaries sell his Amazon stock at $120
2022: Uncle John's estate beneficiaries report capital gains of $0 ($120-$120) and not $100 ($120-$20).
Uncle John’s death increased the Amazon stock cost basis and decreased his estate beneficiaries’ capital gains.
But, before an estate asset is distributed to estate beneficiaries, the estate may sell an estate asset if the estate needs cash for expenses or anticipates a dramatic decrease in the estate asset value or just does not want to maintain vacant property. The cost basis of estate assets held by an estate may also become the fair market value on the date of death.
Normally, capital gains earned by an estate are taxed to the estate itself and the estate income tax rates (on form 1041) for annual estate income are much higher than the individual income tax rates (on form 1040). The tax rate of 37% is applied against estate income over $13,050 and against individual income over $523,600.
To exclude capital gains from the estate income tax, the capital gains must be included on the estate income tax return as distributable net income. Distributable net income is income earned by the estate that is distributed or required to be distributed to estate beneficiaries. The federal regulations, however, state that capital gains are ordinarily excluded from distributable net income.
A decedent’s will could provide that the estate fiduciary may, under a reasonable and impartial exercise of discretion, allocate capital gains to income. Such allocation cannot be prohibited by local law and fortunately Connecticut CGA Sec 12-405a (d) defers to the federal income tax laws in determining deductions under estate income tax.
Therefore, if a will allows the estate fiduciary to allocate capital gains to income and the estate is required to distribute capital gains income within the tax year or the estate does distribute capital gains income within the tax year, then capital gains could be deducted from estate income tax return and taxed on the estate beneficiaries’ individual income tax returns. The consequences of the sale of estate assets before or after distribution to estate beneficiaries should be no different with a properly drafted will and an attentive estate fiduciary.