Inheriting assets can be a bittersweet experience. On one hand, there’s often a sense of profound loss associated with the passing of a loved one. On the other hand, inheriting assets can provide financial stability and opportunities for growth. In any event, it’s essential to understand the concept of adjusted cost basis for inherited assets and what it means for capital gains taxes. The adjusted cost basis can have significant implications for taxes and future financial decisions.
When someone inherits appreciated assets, the cost basis of those assets is adjusted to their fair market value at the time of the original owner’s death.
What Is Capital Gains Tax?
Let’s start by defining key terms. A capital gains tax is imposed on the profit earned from the sale of an asset that has appreciated in value since its purchase. When an asset such as stock or real estate is sold for more than its original purchase price (referred to as the “cost basis”), the difference between the selling price and the original purchase price constitutes a capital gain. A capital gain is subject to capital gains tax. Federal capital gains tax rates range from 0 percent to 20 percent. California taxes all capital gains as income.
What Is an Adjusted Cost Basis?
An adjusted cost basis for inherited assets refers to the adjustment made to the cost basis of an asset upon the death of the original owner. When someone inherits appreciated assets, the cost basis of those assets is adjusted to their fair market value (FMV) at the time of the original owner’s death. This adjustment, often called a stepped-up basis, effectively increases the basis of the inherited assets to their FMV. If the inheritor sells the appreciated asset, he will pay no capital gains tax because of the stepped-up basis. As you can see, the stepped-up basis is very beneficial for taxes.
No Stepped-up Basis for Lifetime Gifts
However, there is a common mistake people make that destroys the benefits of a stepped-up basis. This happens when someone gifts appreciated assets during their lifetime. Assets gifted during one’s lifetime do not receive an increased cost basis; instead, the recipient retains the same cost basis as the donor. For example, if John has stock with $100,000 of gain that he gifts to his daughter, who in turn sells the stock, John’s daughter will pay a hefty capital gains tax on the $100,000 gain.
Avoid pitfalls such as gifting appreciated assets during one’s lifetime or adding a joint owner to appreciated assets.
This pitfall is not avoided by making someone a joint owner. Let’s say that instead of gifting the stock entirely to his daughter, John adds her on as a joint owner so she will inherit the stock upon his passing. Upon John’s passing, his daughter will now only receive a 50 percent stepped-up basis since she was added on as a joint owner during John’s lifetime. I see this happen often with real estate when someone adds their child to the title as a joint owner. This do-it-yourself estate planning technique can end up costing tens or even hundreds of thousands of dollars in capital gains tax.
What to do?
Instead of gifting the stock to his daughter or adding her as a joint owner, John should set up a living trust that states that the stock should be given to his daughter upon his passing. This way, John’s daughter will receive a 100 percent stepped-up basis when she inherits the stock and will avoid the long, public and expensive court process of probate.
While inheriting assets with a stepped-up basis can offer significant tax benefits, it’s essential to avoid pitfalls such as gifting appreciated assets during one’s lifetime or adding a joint owner to appreciated assets without careful consideration of the tax implications. Needless to say, it’s worth seeking professional advice from financial and estate planning experts who can help you navigate these complexities and minimize potential tax liabilities.
Stephen Wood is the founder of Wood Law, Wills & Trusts A.P.C. in Newbury Park. He is a State Bar of California Certified Specialist in Estate Planning, Trust, and Probate Law.
