How Do I Avoid Paying Capital Gains Tax on Inherited Stock?

When you sell an asset like stock for a profit, the gain is often subject to capital gains tax. This tax applies to the difference between the asset’s selling price and its original purchase price. For those who inherit stock from a family member or other benefactor, the tax implications can be a concern. Fortunately, the tax code provides specific rules for assets transferred at death. These regulations can significantly alter the tax liability associated with selling inherited securities, as the treatment of inherited stock differs from stock you purchase yourself.

Understanding Your Inherited Stock’s Cost Basis

The foundation for calculating capital gains tax is the cost basis, which is what you paid for an asset. For inherited stock, this rule changes due to the “stepped-up basis.” Under this provision, the stock’s cost basis is adjusted to its fair market value on the date of the original owner’s death. This means that any appreciation in the stock’s value during the decedent’s lifetime is not subject to capital gains tax for the heir.

To determine this stepped-up basis, you must find the stock’s fair market value on the date the previous owner passed away. This can be found by looking at historical stock price data from public exchanges. This value becomes your new cost basis for calculating any future capital gains or losses.

An ‘alternate valuation date’ may also be used. The executor of the estate may have the option to value the estate’s assets, including the stock, six months after the date of death. This election is made if the overall value of the estate’s assets has decreased since the death, as it can reduce potential estate tax liability. If the executor chooses this alternate date, your cost basis will be its value on that later date.

As a beneficiary, you should confirm with the estate’s executor which valuation date was used for the estate tax return. The executor should provide you with a statement detailing the assets you inherited and their value for tax purposes. This information is what you will use to accurately calculate your tax liability when you sell the stock.

Strategies for Managing Post-Inheritance Gains

Once you understand your new cost basis, you can employ several strategies to manage the tax impact of any gains that accumulate after you’ve inherited the stock. The simplest approach is to sell the shares immediately. If you sell the stock shortly after the inheritance date, its market value will likely be very close to your stepped-up cost basis. This would result in a minimal or nonexistent capital gain, leading to little or no tax liability.

A different strategy involves holding the stock. All inherited property is automatically considered to be held long-term, regardless of how long the decedent or the beneficiary actually held it. This qualifies any gain for the lower long-term capital gains tax rates, which range from 0% to 20% depending on your overall taxable income. This is preferable to short-term gains, which are taxed at your higher ordinary income tax rates.

Donating the inherited stock to a qualified charity offers a way to avoid capital gains tax entirely while also potentially receiving a tax benefit. If the stock has appreciated since you inherited it, you can donate the shares directly to the charitable organization. By doing this, you do not have to pay capital gains tax on the post-inheritance appreciation, and you may be able to claim a charitable deduction for the stock’s full fair market value.

Another method to manage gains is through tax-loss harvesting. This involves selling other investments in your portfolio that have decreased in value. The capital losses generated from selling those investments can be used to offset the capital gains from the sale of your inherited stock. For example, a $5,000 gain from your inherited stock can be canceled out by a $5,000 loss from another investment.

Gifting Inherited Stock

You may consider gifting the inherited stock to another individual, such as a child or other family member. When you gift an asset, the tax rules differ from those that apply to inheritances. The recipient of a gift takes on the donor’s cost basis. In this scenario, your cost basis is the stepped-up value you received upon inheritance.

If you gift the stock to someone else, they will have the same stepped-up basis that you did. They will be responsible for any capital gains tax on appreciation that occurs from the date of the original owner’s death until the day they sell the stock. This strategy does not eliminate the capital gains tax but rather transfers the future tax liability to the recipient.

Be aware of federal gift tax rules. Each year, you can give up to a certain amount to any number of individuals without having to pay a gift tax or file a gift tax return. For 2024, this annual exclusion amount is $18,000. If the fair market value of the stock you gift exceeds this amount, you will be required to file a gift tax return, Form 709.

Reporting the Sale on Your Tax Return

When you sell your inherited stock, you must report the transaction to the IRS on your federal tax return. The form for this is Form 8949, “Sales and Other Dispositions of Capital Assets.” The information from this form is then summarized on Schedule D, “Capital Gains and Losses.”

On Form 8949, you will need to provide specific details about the sale. In column (a), you describe the stock sold, such as “100 shares of XYZ Corp.” For column (b), the date you acquired the stock, you can enter “Inherited.” This signals to the IRS that the asset was received through an inheritance.

You will then report the date of sale in column (c) and the sales proceeds in column (d). In column (e), you will enter your cost basis, which is the stepped-up value determined at the date of death or the alternate valuation date. The difference between your proceeds and your basis will be calculated as your gain or loss, and the totals are carried over to Schedule D.