Inherited & gifted securities

Inherited securities

Death is an unfortunate part of life, and the tax code includes rules that can reduce the tax burden on inherited investments. For inherited securities, two tax-favorable rules apply:

• Cost basis is “stepped up”
• The holding period is automatically long term

When an investor dies, their assets pass to their beneficiaries. The beneficiary’s cost basis becomes the security’s fair market value on the date of the original owner’s death. The beneficiary’s holding period is treated as long term, no matter how long the original owner actually held the investment.

To see how this works, use the following example:

An investor purchases $100,000 of XYZ Stock Fund on January 10th, 2025. The investor dies on June 10th, 2025 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, 2025.

The original cost basis was $100,000, but it is stepped up to $140,000 on the date of death. That step-up can significantly reduce the taxable gain.

• Sales proceeds: $150,000
• Stepped-up cost basis: $140,000
• Taxable gain: $10,000 ($150,000 − $140,000)

If the step-up didn’t apply, the taxable gain would be much larger:

• Sales proceeds: $150,000
• Original cost basis: $100,000
• Taxable gain: $50,000 ($150,000 − $100,000)

The holding period is also long term, even though the shares were held for only about six months.

Assuming the inheritor is in the 32% tax bracket, here’s the difference in tax liability:

With inheritance tax rules

• Cost basis = $140,000
• Sales proceeds = $150,000
• $10,000 realized long term capital gain
• $10,000 gain x 15% (long term gain rate) = $1,500 tax liability

Without inheritance tax rules

• Cost basis = $100,000
• Sales proceeds = $150,000
• $50,000 realized short term capital gain
• $50,000 gain x 32% (short term gain rate) = $16,000 tax liability

So, the inheritance rules reduce both:

• the size of the taxable gain (from $50,000 to $10,000), and
• the tax rate applied (from a short-term rate of 32% to a long-term rate of 15%).

That’s why the tax savings here are $14,500 ($16,000 − $1,500).

Gifted securities

This is a simplification for exam purposes; the actual rules when filing taxes are more complex.

Gifted securities don’t receive the same tax benefits as inherited securities. Instead:

• The original owner’s cost basis carries over to the recipient.
• The holding period also carries over (it doesn’t automatically become long term).

Using the same facts as above, but treating the transfer as a gift:

An investor purchases $100,000 of XYZ Stock Fund on January 10th, 2025. The investor gifts the fund shares to their daughter on June 10th, 2025 when the position was valued at $140,000. The daughter liquidates the shares for a total of $150,000 July 1st, 2025.

In this case, the daughter keeps the original cost basis of $100,000 and the short-term holding period.

• Cost basis = $100,000
• Sales proceeds = $150,000
• $50,000 realized short-term capital gain
• $50,000 gain x 32% (short term gain rate) = $16,000 tax liability