A recent article -- nj.com’s recent article asks, “How will your inheritance be taxed?” -- discusses "cost basis" of inherited assets. Although the article was focused on New Jersey, much of the discussion applies outside of New Jersey as well (i.e. in California). Thus, it is worth summarizing for our readers.
The article explains that typically, the fair market value on the date of the decedent's death is almost always more than the decedent's cost basis. As a result, it’s called a "stepped-up" basis and it’s possible the basis could be lower.
Because of the step-up in basis, if you sell the property right after death, there’s typically no income tax consequence. The gain you’d report on the sale is the sales price minus selling expenses, less the fair market value of the property at the date of death.
As far as investment accounts, the new basis of a security is calculated by taking the mean of the high and low price of the security on the date of death, rather than the close price. Let’s say that the decedent passed away over a weekend. The date of death value is determined by taking the average of:
- the mean of the high and the low value on Friday; and
- the mean of the high and the low value on Monday.
The financial institution will usually give you the investment’s value.
For taxable estates, rather than using the date of death, an alternate valuation date (the date six months after the date of death) can be chosen. In that instance, it must be used to value all of the assets as of the date. You can’t elect date of death value for some assets and an alternate value for others. The IRS also requires consistency in reporting. The basis utilized by the beneficiary as the value of the property received from the decedent, can’t be more than the value of the property reported on the decedent's estate tax return.
For any retirement accounts other than Roth IRAs, income tax must be paid when distributions are made to the beneficiary—like it would have had to be paid on distribution to the decedent. The value of the retirement account in the decedent's estate and/or passing to the beneficiary isn’t reduced by the income tax that will have to be paid on future distributions.
Here’s the difference: if the property is gifted to you, that’s when you obtain the donor’s basis in the property. If you sell the property after you receive it as a gift, it’s more likely that you will have to pay income tax on it, than if you inherited it.
If possible, sit down with an estate planning attorney well in advance of any gift or inheritance and map out the best way to handle the transfer of property.
Reference: nj.com (July 11, 2018) “How will your inheritance be taxed?”