By Laura Johnson, EA
You inherited stock from your late uncle. Or are given legacy shares from your aging mother as part of her estate plan. What are the tax implications for you when you sell? First you need to know your basis in the asset. In the tax context, your basis is the value you use to determine gain or loss on a disposition of property.
The default rule for assets acquired by gift is that the basis in the hands of the gift recipient is the same as it was in the hands of the gift giver. For example: Dad purchased some stock for $10,000 in 2001 and gifted it to his daughter in 2013. His daughter’s basis is $10,000. What about the holding period? Dad’s period of ownership is “tacked on” to his daughter’s holding period, meaning it is as if the daughter owned the stock from 2001, even though she actually received it in 2013. We are using stock as an example, but the same is true for other kinds of gifted assets, for example land or rental properties.
If the value of the gifted property went down between Dad’s purchase and the date of the gift, the basis in his daughter’s hands might be the value on the date of the gift.
The rules are different for inherited assets. In this situation, the basis is “stepped-up” to the fair market value (FMV) on the date of death. For example, you acquired the shares from Dad’s estate in 2006. When Dad died, the stock was worth $30,000. Your basis is $30,000. When sold, the gain or loss is long-term.
“Stepped-up” is a bit of a misnomer as assets can be “stepped-down” if the FMV on the date of death was lower than the decedent’s cost.
Note that inherited retirement accounts, like traditional IRAs or 401k plans, operate under different rules – they do not get a step-up. Check out what we have to say about that here.
Surviving Spouses and Jointly Held Assets
How do the inheritance basis rules apply to jointly held property of spouses? The Tax Code provides the assumption that each spouse owns half of the underlying asset. Half of the asset will be “stepped up,” (that is, the portion belonging to the decedent) and the other half of the asset will retain the original basis (that is, the portion belonging to the surviving spouse). Let’s look at an example. Derek and Meredith were married to each other. They purchased a vacation home in Burlington, VT for $100k in 1994. Derek died in 2016 when the home is worth $300k. Meredith’s basis is now $200k: Half of the house when purchased, $50k, plus Derek’s half that was stepped up, $150k.
Families and their investment advisors should be mindful of these rules when making investment decisions late in life. As you may have surmised, the “step-up” rules have the potential to wipe out a lot of unrealized capital gain on appreciated assets.
For example, a family needs to raise cash to pay for Grandma’s medical care. Grandma’s investment advisor has two positions that is he considering selling. Each sale will generate $100k of cash. The stock of ABC company has a basis of $50k. Stock of XYZ company has a basis of $80k. It may be wise to sell XYZ first. Why? First, there will be less tax to pay on the capital gain, resulting in more cash available for Grandma’s care. Second, is the value of the “step-up.” If Grandma dies owning ABC, the shares will be “stepped-up,” eliminating the appreciation up to the date of death. That is $50k of unrealized capital gain that will never be taxed!
Tax considerations alone should not be the basis for making investment decisions. We are not investment advisors, though we frequently team up with clients’ advisors to seek the best after-tax outcome for our clients.
Be Mindful of Basis
If you have received a gifted asset, do you know your basis? If not, you should inquire sooner rather than later. It can be inefficient to determine basis after the fact, especially if records are incomplete or not available at all.
Executors and estate administrators should be mindful to have accounts valued as of the date of death and updated accordingly. Most financial institutions can do that easily, but be sure to ask. In our experience they don’t do it automatically.
Those in charge of managing estate taxes should also consider an election to use the date six month after the decedent’s death as the valuation date. Making this choice can save estate tax.
Real estate and valuable collectibles should be appraised to determine date of death values, even though an appraisal may not be required if there is no taxable estate. This is especially true if the property has been held for many years or has appreciated significantly.
At John Schachter + Associates, we help our clients determine the basis of gifted assets and help them make the most of planning opportunities. Talk to us. Let us know how we can help you!