Is a beneficiary liable for capital gains tax on a property incurred before he received it?

We all want to know what effect, if any, an inheritance will have on our tax situation. The following is a question received on my blog but it's also one that I'm asked a lot in seminars. I thought I'd share it with you. Here is the question:

If a person inherit a revenue property that was originally purchased many years ago for 100k and is now worth 300k when the beneficiary (that person that inherited)eventually goes to sale the property - say it will be sold for 350k, is he subject to a full capital gain tax, going back to the original purchase price of 100k or just on the gain made from the day he was an owner (50k)?

The fact that the property in question was a revenue property is signficant because it means that the property will be subject to capital gains tax. Let's say the property belonged to Jesse. If it had been Jesse's principal residence, it would have been an exception to the capital gains tax rule, but as it was a revenue property, it will be taxable.

Jesse is responsible for tax on the gain in value from the day he purchased it ($100,000) until the day his estate disposes of it ($300,000). This tax is paid from Jesse's estate. Jesse's executor may not transfer the asset to anyone until the taxes are paid unless he is prepared to risk having to pay those taxes himself.

The property then passes to the beneficiary. Let's call her Laura. When Laura receives the property it's worth $300,000 and when she sells it, it's worth $350,000. Laura is responsible for the tax on this increase in value (i.e. capital gain) only. If I were Laura, I'd want reassurance from the executor of Jesse's estate that all outstanding taxes on the property had been paid in full.

Please understand when reading this post that I have simplified the example to describe how the general rules work. Sometimes there is a delay in an estate and the property ends up sitting in the estate for many months, during which time it increases in value. A beneficiary could be responsible for those taxes. I suggest that executors use experienced estate accountants to deal with capital gains tax questions.