In a previous entry I discussed the difference in taxation of capital gains property and ordinary income property. That piece discussed what happens on your form 1040. But what happens when you die and bequeath these assets to your heirs?
Previously I used the example of a stock that I bought at $100. Now say I leave it to my daughter at my death, and it is trading at $120 on the day I die. How is she taxed? Since stock is capital gains property, she gets a step up in basis to the date of death value. This means that she does not inherit my original basis of $100 – on the date of my death the stock is worth $120, so $120 becomes her new basis. That $20 gain is therefore never taxed! She could turn around and sell the stock the next day for $120 and have no taxable event. She could sell it after one month for $130/share, and have a $10 long term capital gain. Remember, her basis is $120. How is the gain long term when she old held the shares for a month? The gain is always long term on inherited property.
What are capital assets?
What types of assets qualify for a step up in basis? Capital assets – those which are held for a period of time, are subject to market price fluctuations, and are sold at a profit or loss. Think of stocks, bonds, mutual funds, real estate (though not your personal residence), and business interests.
Here’s another example. Say your mother says to you, go ahead and put the Microsoft shares into your name, so they won’t have to go through probate when I die. Sounds like a good move, right? Wrong! Mother & Dad bought the Microsoft in 1970 for $45,000. Today it is worth $445,000. If you transfer the title to yourself, she’s made a taxable gift to you (that’s another tax story for another day), and you receive her basis of only $45,000! What would a smart son do? Say, oh no, Ma – it’s your stock. You keep it and feel comfortable. I can wait. Re-title the account to Transfer on Death so there won’t be any probate. The result? You inherit; your basis is $445,000 – the date of death value – and there is no tax due! That’s $400,000 of gain that is never taxed! Using a capital gains rate of 15%, that is $60,000 that didn’t find its way to the IRS.
Ordinary income property
What assets do not qualify for the step up? Ordinary income property. This is interest received from the bank, annuity gains, and retirement accounts and IRAs.
Annuities do not get a step up in basis, since they are ordinary income property, rather than capital gains property. Clearly there’s a big tradeoff with annuities: you gain income tax deferral of all gains while you’re alive, but your beneficiaries will pay taxes on the gains over your basis. Sort of a high class problem. I wouldn’t complain.
Retirement accounts also do not get a step up in basis. Remember – you made tax-deductible contributions to your IRA and 401K, so what comes out as distributions is ordinary income. It is also therefore ordinary income to your beneficiary, meaning the gain is income-taxable. Again, sort of a high class problem. If, for example, a beneficiary received and distributed $100K from Dad’s IRA, he has an additional $100K in income that year, which pushes him up to a higher tax bracket. There is something called a stretch IRA, which can stretch out the distributions and therefore the taxable event, and I have written a separate blog piece about that.
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