Shares of stock are a valuable asset and may be subject to estate taxes after the death of the owner. The estate is responsible for any estate taxes, not the heirs. Inherited shares of stock are not subject to capital gains taxes until the beneficiary chooses to sell them. Some special rules apply when calculating capital gains or losses for inherited stock.
When an estate is large enough, the stocks and other assets may be subject to federal and state estate taxes. Federal estate taxes apply to estates valued at $5.12 million of more as of 2012 -- a cap that is slated to drop to $1 million in 2013 as of this writing. State estate tax thresholds vary, but are often lower than the federal limit. Stocks are usually valued at the price of the shares on the date of the owner’s death. However, the executor of the estate can use the stock price as of the date six months after the owner passes away as an alternative valuation date. If the stock price falls in the intervening time, this allows the stock to be valued at a lower price, thereby reducing estate taxes.
Inherited Cost Basis
If you inherit stock, you are not responsible for taxable gains that occurred before the date of death. For example, if the stock was originally purchased for $10 per share and the price was $20 on the date of death, the $20 figure is your cost basis and is subtracted from the proceeds when you eventually sell the shares. Another way of stating this is to say the cost basis is “stepped up” from $10 to $20. The IRS forgives any tax liability for gains that occurred while the original owner was alive. If the stock has declined in value since it was purchased, the cost basis is stepped down to the price on the date of death. The beneficiary stock can’t deduct any loss that occurred before the date of death. Only gains or losses that occur after the date of death can have tax consequences for the beneficiary.
Married couples often own stock jointly. When one spouse passes away and the surviving spouse inherits the shares, one-half of the cost basis is stepped up or down to the stock’s value on the date of death. In some states, community property laws require that 100 percent of the basis to be stepped up or down. If the original owner held the shares jointly with someone other than a spouse, the deceased owner’s share is stepped up or down. For instance, if the original owner contributed 60 percent of the investment money, 60 percent of the cost basis is stepped up or down.
Inherited stock is always treated as a long-term capital gain or loss. This rule applies no matter how long the original owner held the shares or how long the heir keeps them before selling the stock. When the shares are sold, the taxable gain is equal to the sale proceeds minus the cost basis on the date of death. As of 2012, long-term capital gains were taxed at a maximum rate of 15 percent. If the sale price is less than the cost basis, the heir realizes a long-term capital loss that may be used as a deduction on his income tax return.