Concerning inheritance of stock, what is taxed? Are inherited stocks long term or short term capital gains? And is there capital gains tax on inherited stocks?
If you have inherited stock or anticipate inheriting some, you are right to start asking these kinds of questions. When inheriting stock, the tax implications are worth knowing because they may determine how much money you end up with in the future.
Taxes on Inherited Stocks
Inheritances of property, like stocks, have no specific tax implications at the federal level until you do something with them. The Internal Revenue Service (IRS) doesn’t collect tax on inherited money, although six states do.
These aren’t income taxes, however, but rather a percentage of the value of a gift that an individual receives from an estate. As far as the IRS is concerned, if you are inheriting stocks and just sit back and watch them grow in value, no tax bill will come due.
However, when and if you cash them out, capital gains taxes can come into play. This tax is assessed on the difference between what it cost you to acquire an asset, called your basis, and the amount you sell it for.
Remember, if you have decided to cash out stocks in your inheritance, you may be forced to pay capital gains taxes if their total value during the sale is greater than their total value when you received them. Holding these stocks for more than a year will significantly lower your tax rate when you decide to sell.
Inheritances Receive a Stepped-Up Basis
Obviously, you don’t purchase an inheritance, so the IRS needs another way to determine your basis in inherited stocks. Inheritances receive what is known as a stepped-up basis, usually to the date of the decedent’s death, although estates have the option of valuing property six months after this date instead.
So, your basis isn’t what the decedent first paid for the stocks. That could be very little, particularly if the purchase was made years ago. If you cash in the stocks immediately after you inherit them, it’s possible that you’d have no gain in value at all, so no taxes would be due.
Capital Losses on Stocks
Given the ups and downs of the stock market, it’s also possible that you could sustain a loss when you decide to sell the stocks. If, for example, they were worth $10,000 on the decedent’s date of death and are now worth $7,500, selling them would result in a $2,500 capital loss.
Again, the stepped-up basis is critical. If the decedent had been losing money on those stocks for years, you can’t tap into those losses. Your losses begin on the date of their death or on the alternative valuation date.
The Effect of a Loss on Other Income
Capital gains and losses are entered on line 7 of IRS Form 1040 just below the Dependents section. They will either reduce or add to your overall taxable income. If you also have earned capital gains from other investments, any additional capital losses are deducted from those gains to reduce the total you must enter that on line 7. You may also be required to attach Schedule D, Capital Gains and Losses.
If the stocks were your only investment property subject to capital gains tax, or if all of your investments lost money, you can enter the negative number of your loss on line 7. However, you can only do this for losses of up to $3,000 a year. That $2,500 would slide in under the limit, but if you lost $3,500, you’d have to claim a $3,000 loss this year and the remaining $500 next year.
The Long-Term Tax Rate
Capital gains tax rates depend on whether you own an asset long term or short term. Normally, you must hold ownership of an asset for at least one year to qualify for the more favorable long-term rates. Any asset owned for less than a year before you sell it is taxed as ordinary income according to your tax bracket, and this can be a significantly higher rate.
However, the IRS taxes all capital gains on inheritances at the lower long-term rate. You can hold the stocks for one day or for 10 years and still receive the same long-term rate. Currently, rates are zero percent for single taxpayers who earn up to $40,400 when filing single. or double that when filing joint returns.
A 15 percent rate applies for those who earn between $40,400 and $445,850 for singles. These thresholds increase to $80,800 and $501,600 for married taxpayers who file joint returns as well as qualifying widows and widowers. For married people filing separate returns, the upper limit is $250,800, while heads of households will pay 15 percent for incomes between $54,100 and $473,750.
Those with incomes higher than these levels will pay 20 percent tax.
Beverly Bird has been writing professionally for over 30 years. She is also a paralegal, specializing in areas of personal finance, bankruptcy and estate law. She writes as the tax expert for The Balance.