What is the cost basis for inherited stock?
Editorial staff, J.P. Morgan Wealth Management
- Generally, the tax basis – AKA cost basis – for inherited stocks is set on the day the estate’s owner passes away.
- Generally, this rule does not apply to stocks that are gifted before death or to irrevocable trusts created before the death of the estate’s owner.
- A step-up in tax basis is a benefit for beneficiaries because it reduces the capital gains tax they may have to pay on the subsequent sale of their inherited assets.
- Consult with a tax professional to evaluate the consequences of selling an inherited stock.
What is inherited stock?
Inherited stock refers to shares of a company that are passed down from the estate of a deceased to their beneficiaries. Unlike the assets you purchase yourself, the value of inherited stock is determined based on its fair market value at the date of the deceased’s death, not when the deceased originally purchased the stock.
Let’s explore an example situation.
Great Aunt Jane was frugal and thrifty. She saved her earnings from ABC Manufacturing to buy Treasury bonds and ABC Manufacturing stock.
After a long and productive life, she died at the age of 95 and left her ABC Manufacturing stock that she had acquired over the last 60 years to her great-great nephew Simon who lives in Brooklyn, New York. Simon talks to his financial advisor who says the stock is a great investment (i.e., the company is still going strong), but it would be wise to diversify his holdings by selling some and reinvesting in other sectors. Simon is worried he’s going to be hit with a massive capital gains tax bill because Jane bought some of these shares in the 1950s.
But he doesn’t need to worry. Let’s discuss why.
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What is tax basis for U.S. tax purposes, and how does that affect capital gains?
Tax basis is generally the original value or purchase price of an asset or investment for tax purposes. Your tax basis in stock is adjusted for certain events such as stock splits and return of capital distributions. Tax basis is used to determine the amount of capital gain you have upon a sale, which is generally equal to the difference between the asset's tax basis and the amount realized on the sale.
Assets, such as your ownership stake in a house or a company’s stock, may increase or decrease in value over time. For example, if you bought $1,000 worth of ABC Manufacturing stock last year, and that $1,000 investment is worth $2,000 today, your value has appreciated 100% in that time. If you decide to sell your $2,000 of stock, you generally will owe taxes on the $1,000 gain – but not on the $1,000 initial investment amount (assuming you used after-tax dollars to make the initial investment). That $1,000 you invested is your tax basis in that stock.
Calculating the tax basis of an inheritance
Back to our example…
Jane bought her shares of ABC Manufacturing over many years. During that period, the company grew, and the shares were split more than once. The adjusted tax basis of the shares she bought in the 1950s has changed multiple times. To complicate matters further, every time Jane bought a small number of shares, the tax basis was different and to get a precise picture of the total tax basis, it would generally be necessary to find the price of the shares each time she made a purchase.
In order to simplify matters, the U.S. Internal Revenue Code of 1986, as amended, generally allows for beneficiaries to receive a fair market value basis for assets they inherit from someone who has passed away. This means that the tax basis in the hands of the beneficiary for U.S. federal income tax purposes may be set to the investment’s fair market value on the date the original owner passes. This adjustment is known as the step-up in basis rule.
How the step-up in basis rule works
The step-up in basis rule allows the tax basis of an inherited asset to be adjusted to its fair market value on the date of the original owner’s death. This adjustment can potentially reduce the capital gains taxes the beneficiary might owe when the asset is sold, since the taxable gain will be calculated based on its value at the time of inheritance rather than its original purchase price. In our earlier example, Simon benefits from the step-up in basis rule, though this does not apply uniformly to all assets. For instance, retirement accounts such as 401(k)s and IRAs are governed by different tax rules. Speaking with a qualified tax professional can provide more specific guidance there.
The step-up in basis rule is great news for beneficiaries if the asset has increased in value since the original owner’s purchase, because it would generally mean that the amount the beneficiary would pay in capital gains taxes arising from a subsequent sale of the asset would be lower than if this rule didn’t apply. In the example above, Simon’s tax basis for U.S. federal income tax purposes is whatever the value of the investment was on the day of Jane’s death.
Since Jane left him ABC Manufacturing stock, and he knows the day she died, he can see what the average of the high and the low of the stock was on that day, which is a method that may be used to determine the fair market value of the stock and his tax basis. If he decides to sell some of the stock and reinvest the proceeds, he will have to pay capital gains taxes only on the value it has gained since her death.
Tax on inherited stock: Considerations
Death and taxes are sometimes relatively simple, but there are still some possible complications to be aware of.
- Reinvested dividends: If the shares Jane bequeathed to Simon were held in a brokerage account, and the dividends were set to automatically reinvest, the account may have bought new shares since the valuation date of the shares, which would have a new tax basis.
- Inherited stock vs. gifted stock: The step-up in tax basis applies only to inherited stock. Stock gifted before death or to an irrevocable trust made before death generally do not receive this special tax treatment. Those stocks generally receive carryover basis, meaning they take the basis the donor had in that asset.
- Investment type: The step-up in basis treatment generally applies to only non-qualified investments – those investments that don’t normally get preferential tax treatment. Distributions from inherited qualified investments such as 401(k)s or IRAs are generally taxable as ordinary income.
The bottom line
The cost basis of inherited stock is generally based on the fair market value of the shares at the time of the original owner’s death, rather than when they were first purchased. This is based on the step-up in basis rule, which can potentially reduce capital gains taxes on inherited assets. However, tax laws are complex, and every person’s financial situation is unique; consider speaking with a qualified tax professional for how these rules apply in your case.
Frequently asked questions
Whether it’s better to inherit cash or stocks depends on various factors like your overall financial goals and liquidity needs. For example, inheriting cash can offer flexibility to be used for immediate expenses or investment opportunities. On the other hand, inheriting stocks can provide the potential for growth and can have certain tax-advantages like a step-up in cost basis. Each situation is unique and you should consult with your tax and J.P. Morgan advisors.
You may receive the stocks already in your name if the original owner named you as their transfer-on-death beneficiary before passing. If not, the transfer process to put the stocks in your name may require a stock transfer agent, such as a bank or trust company, to establish ownership.
Determining which assets go to whom and at what point may be articulated in a will or revocable trust during the estate settlement process. The assets may also pass to your named beneficiary based on the way your accounts are titled. Speaking to a trust and estate attorney can help determine how you should structure your wealth transfer.
Once you officially inherit the stock, you can sell your shares at any time, similar to how you would cash out any other stock or asset. Note that selling inherited stock may have tax implications depending on your timeline. Consult with a tax professional to evaluate the consequences of selling an inherited stock.
Inherited stock generally doesn’t incur taxable capital gains on any growth prior to your inheritance, but any change in value thereafter will likely result in capital gains taxes on that amount when sold.
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Editorial staff, J.P. Morgan Wealth Management
