If the beneficiary of a trust receives an asset valued at $500,000 but was purchased for only $100,000, does the beneficiary incur a big tax bill? For many, this could be a crippling tax bill. However, the IRS code does provide some relief for beneficiaries of inherited assets. This relief comes in the form of an adjustment to the original cost basis.
What Are Inherited Assets?
An inherited asset can include nearly anything. But depending on the asset and relation to the beneficiary (i.e., the person inheriting the asset), the amount of taxes owed can vary. This is because, at the federal level, there is no inheritance tax, but there may be an estate tax. The estate and beneficiaries may also owe state taxes.
Non-retirement assets receive a step-up in basis upon the death of the person willing assets. Upon their death, the assets will transfer to beneficiaries at the fair market value. The tax advantage for beneficiaries is that they don't pay any federal taxes on gains of the assets.
If a beneficiary later sells an inherited asset for a gain, long-term capital gains taxes are generally owed on the gain.
Note for investments, the step up in basis applies only to brokerage or individual accounts. Retirement accounts such as 401k, 403b, or traditional IRA roll into a beneficiary or inherited IRA. The beneficiary must pay ordinary income tax rates on distributions from these assets. Because these are considered death distributions, there is no penalty if distributions occur before age 59.5.
Calculating The Cost Basis On Inherited Assets
In simple terms, the cost basis is the price paid for a capital asset. During an investor's lifetime, those assets may appreciate. Once they are distributed to beneficiaries after death, no federal taxes are owed on the gain.
As an example:
Purchase price of asset: $100,00
Market value at the time of death: $500,000
Transfer value to the beneficiaries: $500,000
While there is a $400,000 gain on the asset, the cost basis steps up from $100,000 to $500,000 upon the investor's death, basically showing no gain for beneficiaries.
However, if the investor had sold the asset one day before dying, he would have realized a long-term capital gain of $400,000.
Once the asset is inherited at $500,000 and the beneficiary later decides to sell it at $600,000, they will realize a long-term capital gain of $100,000 due to the stepped-up basis. Whether the asset is sold within a year or more after inheritance doesn't change their long-term capital gains status.
On the other hand, if assets are sold for less than $500,000, the beneficiary will incur a realized loss. The beneficiary can write this loss off at $3,000 annually until the entire loss has been declared.
In summary, beneficiaries receive a step up in the cost basis of inherited assets. The new basis is calculated as the market value upon the death of the person willing the assets.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Hypothetical examples shown are for illustrative purposes only.