Taxation Guide to Stock Inheritance

Unless you leave or inherit an estate of $11 million, stock inheritance is not subject to income tax until it is sold. So, only high-net worth individuals and their heirs need to be concerned about estate and inheritance taxes. In fact, under IRS rules, most inheritance is not considered income, and need not be reported. If you sell the stock, however, you must report the proceeds as short- or long-term capital gains.

Whittling down the inheritance taxes

So, for wealthier clients estate planning specialists advise whittling down the estate tax bite by giving heirs an advance on their inheritance. The current limit exempting the donor from paying gift taxes is $15,000 per year, per person. That 15 grand doesn’t have to be just cash. It can be stocks, bonds, and other assets.

Capital gains taxes are the government’s share of sales profits

When inherited or gifted assets increase in value, the IRS assesses a capital gains tax when those assets are sold. Capital gains taxes vary according to how long you hold on to the asset. Keep the stock for a year or less, and pay short-term capital gains as normal income and according to your tax bracket. Hold on to those access for the long term, and you’ll pay 15% on those gains if you’re in the middle-income bracket—20% if your income level exceeds $425, 801.

Cost basis and step-up cost

The tax rules for inherited mutual funds/stocks held outside retirement accounts include the principles of cost basis and step-up cost. When calculating capital gains taxes, the amount the buyer originally paid for the stock is known as the cost basis.  For tax purposes, the cost basis is the fair market value of the stock on the date the owner dies.

Between the time the decedent bought the stock and the date of death, the stock value change is its step-up in cost basis. That means that if your parent bought a stock for $150 and the stock increased in value to $300, the step-up basis is $300. You are not taxed on that $150 increase; however, you will pay capital gains on the increase in value over that step-up value if you sell the stock.

One interesting feature is the choices involved in figuring the fair market value of the stock:

1. you can choose the fair market value of the stock to be the date of death of the owner; or
2. you can choose the fair market value as of 6 months following the death of the original owner.

Choose option #2 (the six months option), and there could be an alternate valuation of the stock value resulting in either a capital gain or a loss.

So, the tax code treats inherited stocks rather more gently than, say, early cash-out of an IRA. Whoever inherits stock pays no tax on gains in value that occurred during the previous owner’s life. If you hold on to the inherited stock to qualify for low long-term capital gains rates, pay a low tax.

How to report the sale of stock

You must report a return on the sale of stock on IRS form 1040, Part II of Schedule D, Capital Gains and Losses. Report the sales proceeds in column (d). Report your “basis” in column (e). Since the basis is reported at the fair market value on the date of death (or six months subsequent), this should help minimize any tax gain you might have.

Looking for quality advice on family estate planning?

Chandler & Knowles advisors and tax planning experts can help you pass on your estate with minimal taxation. Contact us and learn more about our estate planning services.