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How Tax Break for Sale of Inherited Property Works

Oct 17th 2016
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The tax laws provide an important advantage for people who sell inherited investments that have appreciated in value – stocks and real estate, to cite some common examples. Here’s a rundown of how this break works.

Suppose Uncle Albert writes a will that says you inherit appreciated stocks or other property. When you sell the shares, you qualify for special treatment – a “step up” in basis (the figure from which gain or loss is measured) for the property from its original cost to its value on the day he died. In certain cases, instead of date of death, it’s the property’s value six months thereafter, if an executor chooses an alternative valuation date.

Put more plainly, you escape paying any capital gains taxes on the amount the stocks appreciated while Albert owned them. You’re taxed – if and when you sell – only on post-inheritance appreciation.

An example: Albert originally paid $10,000 for shares worth $250,000 when he died and left them to you. You later sell them for $300,000. Because your basis for the property is considered to be $250,000, your taxable profit is only $50,000 – the increase in value between the time your benefactor died and the time you unload the stock. You’re off the hook for any income taxes on the $240,000 increase in value between the time of Albert’s stock purchase and his death. The amount he paid for the stock is irrelevant.

Assume, instead, you sell the shares after they drop in price from $250,000 to $235,000. You have a capital loss of $15,000. The law allows you to fully subtract that loss from any capital gains. What if losses exceed gains? Then you can subtract as much as $3,000 ($1,500 for married couples who file separate returns) from ordinary income – salaries, pensions, and interest, for instance. You get to carry forward any unused loss of more than $3,000 to the following year and beyond, if necessary.

Confusion abounds about the interplay of income taxes and estate taxes. The step up in basis that allows you to sidestep income taxes doesn’t enable Albert’s estate to escape estate taxes that are otherwise due. As is true of his other assets, estate taxes are figured on the stock’s $250,000 date-of-death value, not its $10,000 original cost.

There’s also a step up in basis when you hold an asset in joint ownership with a spouse who dies. The step up is for half the basis, not the entire basis.

To illustrate, John and Mary paid $50,000 for stock they hold in joint tenancy with right of survivorship. The shares were worth $100,000 at her death. He inherits a half interest and automatically becomes the owner of all of the shares. John’s stepped-up basis becomes $75,000 – the sum of his half of the $50,000 original basis ($25,000), plus half of the $100,000 date-of-death value ($50,000). On a later sale, only appreciation above $75,000 gets nicked for income taxes.

There’s no step up in basis for a transfer of appreciated property from a donor to a donee when the donee dies within a year and the property returns directly or indirectly to the donor or the donor’s spouse. Consequently, the basis remains whatever it was at the time of the transfer from the donor to the donee. The purpose of this one-year restriction is to deny a tax break to a donor with appreciated property who arranges a transfer of it to a very ill donee on whose death the property then reverts back.

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