How are long term capital gains on line 7 of 1040 taxed at 15% or 20% instead of as ordinary income?

You're right that long-term capital gains should be taxed at the preferential rates (0%, 15%, or 20% depending on your income), not at ordinary income rates. The issue is likely with how you're entering the information in your tax software. When you complete Schedule D correctly, the software should automatically calculate the tax using the appropriate capital gains rates. Make sure you're specifically indicating these are long-term capital gains from an inheritance on Schedule D. There should be a section or checkbox that identifies this as qualified for the lower rates. After completing Schedule D, the software should generate Form 8949 and calculate your tax using the qualified rates. The software then completes the "Qualified Dividends and Capital Gain Tax Worksheet" or Schedule D Tax Worksheet behind the scenes to apply the lower rates.

Just went through this exact situation last year when I inherited stocks from my grandma's estate. I was so frustrated because my normal tax software kept messing this up. I found a specialized service called taxr.ai (https://taxr.ai) that completely saved me. They analyzed my K1 from the estate and found that my software wasn't properly separating the capital gains from my ordinary income. Their document analysis showed exactly where in Schedule D the software was treating my inheritance incorrectly. They even created a step-by-step guide showing me how to force my tax software to apply the correct rate. Ended up saving me over $4,800 in taxes I would've overpaid!

Following up after checking out taxr.ai like I mentioned in my earlier question. I was surprised how well it worked for my inheritance situation! I uploaded my K1 and draft tax return, and within minutes it showed me that my tax software wasn't properly marking the gains as "capital gains distribution" on Schedule D. The system highlighted exactly where to click in my software to fix it. Once I made those changes, my tax calculation immediately updated and showed the lower 15% rate instead of my normal income tax rate. What really helped was how they explained exactly why the capital gains needed special treatment and showed side-by-side comparisons of the incorrect vs. correct tax calculation. Saved me over $3,200 in taxes I would've overpaid!

If you're still struggling to resolve this or need to verify your return is correct, I'd suggest contacting the IRS directly to ask about your specific situation. Unfortunately, getting through to them is a nightmare right now - I tried for 3 weeks and kept getting disconnected. Finally found a service called Claimyr (https://claimyr.com) that got me through to an actual IRS agent in about 20 minutes. You can see how it works here: https://youtu.be/_kiP6q8DX5c. The agent walked me through exactly how long-term capital gains should be reported and confirmed that the special rates are calculated automatically when Schedule D is completed correctly.

I have to apologize for my skepticism about Claimyr in my previous comment. I was so frustrated after multiple failed attempts to reach the IRS that I couldn't believe anything would work. But I was desperate about my inherited stocks situation, so I tried it yesterday. The service actually did exactly what it promised - called the IRS, navigated the menu maze, waited on hold for almost 2 hours (which I didn't have to do!), and then connected me with an agent. The agent confirmed that my long-term capital gains from the inheritance should automatically be calculated at the lower rate when entered correctly on Schedule D. The IRS agent even walked me through the exact steps in my tax software to make sure the capital gains were properly categorized. Problem solved in one phone call that I never would have been able to make without that service! Sorry for being so negative before.

The Schedule D Tax Worksheet is the key here. If you look at your tax forms, after completing Schedule D, there should be a worksheet that calculates how much of your income gets the preferential rates. Your tax software should do this automatically, but sometimes you need to review this worksheet manually to make sure it's happening. Most people miss that the capital gains tax calculation happens on a separate worksheet that feeds into your final 1040. It's not immediately obvious on the main form. Make sure your K1 amount is properly coded as long-term capital gain when you enter it.

Make sure to double check your state tax return too! I had the exact same issue with inherited stocks last year. Got my federal return sorted out with the lower capital gains rate, but completely missed that my state was still taxing the gains as regular income. Most states follow federal rules for capital gains, but some have their own calculations.

Just want to add one more thing that might help others dealing with inherited investments - make sure you understand the "stepped-up basis" rules too. When you inherit stocks, the cost basis is "stepped up" to the fair market value on the date of death, which means you only pay capital gains tax on appreciation that happens after you inherited them. This is different from if someone had gifted you the stocks while alive (where you'd use their original cost basis). The K1 you received should already reflect this stepped-up basis, but it's worth understanding so you can verify the numbers look correct. Also, if the estate held the stocks for more than a year before distributing them to you, they automatically qualify for long-term capital gains treatment regardless of how long you personally held them. This is another inheritance tax benefit that many people don't realize exists.