How Inherited Assets Differ From Gifts

We all love getting gifts. But sometimes receiving a gift today may cost you later in capital gains taxes.  So, when it comes time to passing your assets to your children and other loved ones, one should understand the pros and cons of lifetime gifts versus an inheritance.

When you receive cash or other valuable assets as a gift you do not owe income tax on those assets. This is true regardless of whether the gift is given during the lifetime of the donor or if it is received as an inheritance. The donor may owe a gift tax, and the estate may owe an estate tax, but recipient does not owe a tax upon the receipt.

This is great news. Now comes the not-so-great news. If you received a non-cash asset as a gift or inheritance and subsequently sell that asset, you will incur tax consequences. The extent of your tax consequences depend on your “basis” in the asset.

Basis is essentially the original cost of property, adjusted for various factors like depreciation, capital improvements, stock splits, dividends and return of capital distributions. There are two main types of “basis” that relate to gifts given during life and gifts received as an inheritance: carryover basis and stepped-up basis.

Carryover basis – When you receive an appreciated asset as a gift, you also receive the giver’s basis in that gift. This means that the previous owner’s basis “carries over” to you.

For example, let’s look at Joe’s situation. Joe invested $10,000 in ABC Corp. stock many years ago. Joe always received the dividends from ABC, rather than reinvesting them. When the shares are worth $19,000, Joe gives those shares to his nephew Sam. In this scenario, Sam retains Joe’s $10,000 basis in the shares. If he sells the shares for $22,000, Sam will owe tax on the $12,000 gain instead of owing tax on the $3,000 gain since the gift.

For gifts of appreciated assets, the donor’s holding period also carries over. Here, Sam will have a favorably taxed long-term gain because Joe held the shares for many years. In another situation, where Sam’s sale takes place one year or less since Joe’s purchase, her $12,000 gain would be taxed at higher ordinary income rates. This is considered a short-term gain.

Stepped-up basis – Different rules apply to inherited assets. Here, the heir’s basis typically is the value of the asset on the date of death of the owner.

For example, Robert Smith dies and leaves $200,000 worth of XYZ Corp. shares to his neice Maggie. Even if Robert’s basis in the shares was only $90,000, Maggie’s basis in the shares is $200,000, which was the value when Robert died. Maggie will have no taxable gain on a subsequent sale for $200,000, a $10,000 gain on a sale for $210,000, and a $5,000 capital loss on a sale for $195,000.

Depreciated assets are stepped down. For instance, if Robert had bought the shares for $200,000, but they were worth $90,000 when he died, Maggie’s basis would be $90,000. After an inheritance, sales generally are taxed as a long-term gain or loss, regardless of the holding period.