The Internal Revenue Service has specific rules that deal with how inherited property, such as stocks, is treated. Knowing your basis in the inherited stock can help you anticipate the tax implications of selling it, which allows you to time your sales to create the lowest resulting tax burden.
When you buy and sell property, the taxable amount of your gain is determined by subtracting your basis, which is the amount you are credited with paying for the property, from the selling price. This prevents you from being taxed on money that isn't really a gain. For example, if you buy a stock for $100, your basis is $100. If you later sell it for $110, you would have a $10 taxable gain because your sale price is $10 more than your basis. If you did not account for your basis, you would pay taxes on a $110 sale price.
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Typically, inherited property receives a step-up or step-down in basis to the fair market value on the date of the decedent's death. For example, if the decedent purchased the stock for $10 per share twenty years before, and the share price was $400 on the decedent's date of death, your basis for the inherited stock would be $400. Alternatively, if the decedent bought the stock for $40, and it was worth $30 on the date of death, you, as the heir, take the stock with a basis of $30 per share.
If the estate owes federal estate taxes, the executor may choose a different valuation date. This is allowed as long as the date is the earlier of six months after the date of death or the date the shares are given to the heir. In this case you would have to use the alternative date for the tax basis.
Calculating the Basis of Shares
The basis of each share is determined by averaging the high and low price on the date the decedent died. For example, if on the day the decedent died, the stock traded between $90 and $94, the average is $92. If the decedent died on a non-trading day, such as a weekend or holiday, the basis equals the average of the high and low values for the last trading day before, and the first trading day after, death. For example, if a decedent died on Sunday, the heir would use the average of the high and low from Friday and the high and low from Monday to calculate the basis for the inherited stock.
Extended Holding Period
Long-term capital gains are taxed at a lower rate than ordinary income. Typically, to qualify for capital gains rates, you must hold the property for more than a year. However, when you receive stocks as an inheritance, you automatically qualify for the lower long-term capital gains rates when you sell the stock, no matter how long you own the stock. This is significant if you sell the stock within one year of owning it because you still qualify for the lower capital gains rates. For example, if you buy a stock and sell it four months later, you would have to treat the gain as a short-term, subject to ordinary income tax rates. However, if you inherited the stock, you would be eligible for the lower capital gains treatment.
If you inherit a tax-deferred retirement plan that includes stocks, such as an IRA or 401(k), you do not receive the step-up in basis because distributions from the plan are considered income in respect of the decedent. These distributions are taxable to the heir as they would have been to the decedent. For example, if you inherit a traditional IRA containing stocks, to which the decedent made only fully deductible contributions, the basis would be zero. This is because none of the money contributed to the account was previously taxed. Therefore, all of the distributions would be taxable to you as the beneficiary.
Mark Kennan is a writer based in the Kansas City area, specializing in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."