Death is an unfortunate aspect of life, but the IRS tries to make grieving easier by reducing tax burdens on inherited securities. In particular, two tax-beneficial things occur:
When an investor dies, their assets are passed on to their beneficiaries. The new cost basis of the security reflects the value on the day of the original owner’s death. Also, the holding period for the inheritor is long-term, regardless of how long the original owner held the investment. To better understand this, let’s assume the following:
An investor purchases $100,000 of XYZ Stock Fund on January 10th, 2022. The investor dies on June 10th, 2022 when the position was valued at $140,000. The shares are inherited by the investor’s daughter, who redeems the shares for a total of $150,000 July 1st, 2022.
Although the position initially established a cost basis of $100,000, it is “stepped up” to $140,000 upon the original owner’s death. The step up reduces taxation considerably. With a total liquidation value of $150,000, the daughter locks in a taxable gain of $10,000 with the step-up ($140,000 cost basis vs. $150,000 sales proceeds). If the step-up didn’t occur, the inheritor would’ve reported a $50,000 taxable gain ($100,000 cost basis vs. $150,000 sales proceeds). Additionally, the gain is long-term, although the shares were only held roughly six months.
Assuming the inheritor is at the 32% tax bracket, let’s look at the difference in tax liability:
With inheritance tax rules
Without inheritance tax rules
As you can see, the inheritance tax rules can significantly reduce tax liability. Instead of paying a 32% tax (tax bracket applies to short-term gains) on a $50,000 gain, the inheritor only pays a 15% tax on a $10,000 gain, resulting in tax savings of $14,500.
This is a simplification for exam purposes; the actual rules when filing taxes are more complex.
Unlike inherited securities, gifted securities are not eligible for tax benefits. The original owner’s cost basis transfers directly to the person receiving the securities. Additionally, the holding period does not adjust. To better understand this, let’s use the same example above (adjusted to be a gift):
An investor purchases $100,000 of XYZ Stock Fund on January 10th, 2022. The investor gifts the fund shares to their daughter on June 10th, 2022 when the position was valued at $140,000. The daughter liquidates the shares for a total of $150,000 July 1st, 2022.
In this case, the daughter retains the original cost basis of $100,000 and the short-term holding period.
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