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The Wealth & Wisdom Blog

Information on Estate Planning, Estate and Trust Administration and Unique Asset Planning

Under federal income tax law, a capital gains income tax is imposed on the difference between the price for which an investment is sold and the price for which the investment was originally purchased. For example, if Joe purchases a stock for $10, then sells it at $110, Joe will owe a capital gains tax on the difference of $100.  Keep in mind that if Joe currently holds the stock, no capital gains tax is imposed until Joe actually sells his stock.  

However, if Joe were to die before selling the stock, the rightful beneficiaries of his stock (his “heirs”) would receive what is called the “step-up in cost basis.”  Through this rule, his heirs receive the benefit of receiving the stock as if they were the ones who originally purchased the stock at a price equal to the fair market value as of the date of Joe’s death.  For example, if the stock were valued at $110 as of Joe’s death, then for purposes of determining a capital gains tax liability, Joe’s heirs would receive the stock valued at $110 as if they had purchased the stock for $110.  The sale would therefore trigger no capital gains tax liability.

In contrast to property received at death, the heirs of property received as a lifetime gift receive a “carry-over cost basis.”  A carry-over cost basis means that the recipient would have the same cost basis as the original donor.  If Joe’s cost basis was $10 when he gifted a stock worth $110 to Bob, then when Bob subsequently sells the stock for $110, Bob will face a capital gains tax liability based upon the full $100 differential ($110 sale price less the $10 original cost basis).  Unfortunately, many well-meaning individuals have transferred highly-appreciated assets during their lifetime, and the heirs “pay the price” for the application of the carry-over basis rule.  If these individuals had held on to these assets, and owned the assets at death, the heirs would have benefited from a reduced capital gains tax liability through this step-up in cost basis rule.