When you make an investment, the price you pay for the asset is called your “cost basis.” This is the threshold amount for calculating the capital gains taxes that are required when you sell. If you buy 100 shares of Berkshire Hathaway (BRK.B) for $166 in 2016, and then sell them at $250 in 2021, your 23.8% tax requirement is one the difference between $166 and $250. The $84 gain requires a $19.99 tax payment, leaving the investor with $64.01 x 100 = $6,401 in net-of-tax investment gains that gets added to the $16,600 initial investment for a total investment value of $23,001.
As part of estate planning, it is important to know which of your assets receive a “stepped-up” cost basis upon on your death when the ownership transfers to your heir or beneficiary. Stepped-up cost basis means that that the starting point of a tax analysis readjusts upward upon the owner’s death. If, instead of selling your stock in 2021, you die in 2021 when Berkshire trades at $250 per share, your son or daughter that inherits the stock as a beneficiary only has to pay for the price appreciation above the $250 value. If the son or daughter immediately sells the hundred shares, the result is a pocketing of the $25,000 with no payment owed to the state or federal government.
The reason why the stepped-up cost basis exists is because state and federal governments apply taxes to the entire value of an estate that gets transferred, and it would be an act of double taxation to tax the estate value and then tax the beneficiary a second time upon selling the stock.
However, it is important to note that there are six types of inheritance property (called income in respect of a decedent property) that do not receive a stepped-up cost basis at the time of death.
If you inherit a deferred annuity or a joint-survivor annuity with survivor benefits, any earnings that you receive will be taxed at your ordinary income tax rate.
If you inherit any accounts receivable from a business, you will be taxed at your ordinary income tax rate. Imagine if your dad was a plumber and he died with $22,200 in bills from customers that haven’t yet been paid. Over the course of the next month or so, you find that you’re able to collect on $21,500 of that. These funds all get taxed at your ordinary income tax rate.
If you inherit any deferred compensation, you will be taxed at your ordinary income tax rate.
If you inherit any commissions or royalties, you will be taxed at your ordinary income tax rate. If your mom is a book author and her royalty payments continue to generate $2,000 per month in income after her death, and you get assigned the royalty payments as an inheritance, that $2,000 will get taxed at your ordinary income tax rate.
If you inherit an individual retirement account (IRA) such as a traditional IRA that consists of pre-tax contributions, the funds that you receive will be taxed at your ordinary income tax rate. This one sometimes catches beneficiaries by surprise because it is often the central significant asset.
If you inherit the right to collect payments that are part of an installment payment plan, then you will have to pay taxes at your ordinary income tax rate.
The good news is that there is an accompanying deduction called the income in respect of a decedent (IRD) deduction that primarily acts to reduce tax liability when both estate and income taxes can be applied to inherited property. The specifics of this deduction are fact specific based on the amount and structure of the estate, and it usually requires the assistance of an accountant or a tax professional to apply correctly. When crafting your estate, it is important to note that traditional IRA assets and yet unpaid earnings from your labor will get taxed at the ordinary income tax rate of your beneficiary possibly offset in part by an IRD deduction.