You realize a capital gain or loss when you sell shares of stock. Tax basis, also called cost basis, is the amount you exclude from the net proceeds of the sale to determine the gain or loss. When you sell stock you have inherited, you must still report any capital gain you are responsible for on your tax return, and you’ll want to deduct any losses. However, determining your tax basis is more complicated because you are not the person who made the original investment.
Tax basis is normally the total amount of money you invested. The tax basis for stock investments includes broker’s commissions you paid in addition to the price of the shares. When you inherit shares of stock, there is no investment on your part. At the same time, the stock may show a gain or loss after it becomes your property. The Internal Revenue Service has created rules for determining the tax basis of inherited stock. One thing that makes this simpler is that capital gains and losses on inherited shares are always long term.
Step Up, Step Down
The basic rule for determining the tax basis of inherited stock is to use the fair market value on the day the original owner passed away. If the stock has risen in price since the owner bought it, the tax basis is stepped up to the price on the date of death. Any tax that would have been due on the gain up to that point is disregarded. If the stock has fallen in value, the tax basis is stepped down. The capital loss attributable to a fall in the stock price between the time the owner purchased the shares and the date of death is disregarded and you cannot claim it as a tax write-off. You can only claim a loss due to a decline in the stock price that occurred after you inherited the shares.
Alternative Valuation Date
In general, federal estate taxes may be levied when the value of the estate's assets totals $5 million or more. When this is the case the executor of the estate may be able to use the alternative valuation date rule. This rule allows the executor to use the price six months after the owner’s death as the tax basis if the stock has gone down in value during that time. The lower tax basis means the value of the estate is decreased, which in turn reduces the amount of federal estate tax.
Sometimes a married couple owns stock jointly. When one spouse dies, the tax basis of the inherited portion may be determined in two ways. Usually one-half of the tax basis is stepped up to the fair market value on the date of death. However, in some states community property laws require that the entire tax basis be stepped up. If you inherit stock you owned jointly with someone you were not married to, the portion of the tax basis that is stepped up or down is the same as the proportion of the investment attributable to the deceased. For instance, if the deceased owner provided 40 percent of the stock investment money, 40 percent of the tax basis is stepped up.