How to Track Capital Gains on Inherited Stock

Tracking capital gains on inherited stock can be a complex but crucial task for individuals who inherit assets, particularly stocks or other investments. Unlike other assets, stocks come with unique rules when it comes to taxation. Understanding how to track the capital gains on inherited stock is essential for ensuring proper tax reporting and compliance. This guide will explore how to approach tracking capital gains on inherited stock, breaking down the key elements of the process, including understanding the "step-up in basis," the role of brokerage firms, and how to report capital gains on tax returns.

Understanding Inherited Stock

When you inherit stock, the IRS treats the stock differently than if you had purchased it yourself. One of the most important concepts to understand when inheriting stock is the "step-up in basis." The basis of an asset is its value for tax purposes, and this concept plays a significant role in how you track capital gains.

The Step-Up in Basis

The "step-up in basis" is a tax rule that adjusts the value of an inherited asset, like stock, to its market value on the date of the decedent's death. This is important because it minimizes the capital gains tax liability for the heir.

For example, let's say you inherit stock that was purchased by the decedent for $10 per share, and at the time of death, the stock is worth $50 per share. Under the step-up in basis rule, your new cost basis is $50 per share, not the original $10. This means that if you sell the stock for $60 per share after inheriting it, your taxable capital gain is only $10 per share ($60 sale price minus $50 step-up in basis), not $50 per share.

No Step-Down in Basis

In contrast to a step-up, there is no "step-down" in basis. If the stock's value at the time of death is lower than the purchase price, you do not incur a loss on the inherited stock immediately. The tax system simply does not allow a reduction in basis for inherited assets, which is beneficial for minimizing taxes on a loss.

Tracking Inherited Stock for Capital Gains

To track the capital gains on inherited stock, follow these steps:

Step 1: Determine the Date of Death

The date of death is crucial when determining the step-up in basis. The value of the stock on this date is used to adjust the cost basis. It is essential to have an official record of the date of death for accurate tracking. The price of the stock on that date is usually available from financial publications, brokers, or public records.

Step 2: Locate the Fair Market Value (FMV)

The fair market value of the stock on the date of the decedent's death is key to determining your adjusted basis. This value is not the price on the day before the death or after, but rather the exact closing price on the date of death. This may require you to consult with the deceased person's brokerage firm or use other resources to obtain this information.

Step 3: Identify Your Cost Basis

Once you have the fair market value on the date of death, that is your new cost basis. If you inherited 100 shares of stock and the stock was worth $50 per share on the date of death, your total cost basis for the inherited stock is $5,000 (100 shares x $50). If you sell the stock later for more than $50 per share, the difference between the selling price and this basis will be your capital gain.

Step 4: Record Any Dividends or Stock Splits

Keep track of any dividends received or stock splits that may affect your holding. These events can have an impact on the total number of shares you own or the value of your investment. If the stock undergoes a split or dividend reinvestment plan, record the new number of shares and adjust the cost basis if necessary.

For example, if the stock splits 2-for-1 after you inherit it, you now own twice as many shares. However, your total cost basis does not change; it is simply divided between the additional shares. The adjusted basis per share is halved, but the total investment remains the same.

Step 5: Keep Track of Additional Costs

Sometimes, when inheriting stock, there may be additional costs associated with the transfer, such as legal fees, executor fees, or transfer fees. These costs can be added to the cost basis, reducing your taxable capital gain when the stock is sold. For instance, if you incur $1,000 in costs related to the transfer, that amount can be added to the cost basis, which would reduce the taxable gain when the stock is sold.

Step 6: Monitor Your Shares

After inheriting the stock, keep detailed records of all the transactions related to it. This includes keeping track of the number of shares you own, the price at which you bought the stock (step-up in basis), and any subsequent transactions, including sales or dividend reinvestments. This will make it easier to report any capital gains or losses when you sell the stock in the future.

Tax Implications of Selling Inherited Stock

When Do You Have to Pay Taxes?

The tax liability on inherited stock is based on the capital gains you realize when you sell the stock. You are only taxed when you sell the stock, and the amount you are taxed on depends on how much the stock appreciated from the time you inherited it.

• Short-Term vs. Long-Term Capital Gains: Inherited stock automatically qualifies for long-term capital gains treatment, regardless of how long you hold the stock before selling. This means you are taxed at the lower long-term capital gains rate, which can range from 0% to 20%, depending on your income level.
• Tax Rates for Long-Term Capital Gains: The IRS taxes long-term capital gains at a reduced rate compared to ordinary income. The rates are typically 0%, 15%, or 20%, based on your taxable income. For higher-income individuals, additional taxes may apply, such as the Net Investment Income Tax (NIIT) at 3.8%.
• Reporting the Sale: When you sell inherited stock, you must report the transaction on your tax return. This includes reporting the sale price, the amount of gain, and the cost basis. The gain is calculated as the difference between the sale price and your adjusted basis. Your broker will issue a Form 1099-B for the sale, which will help you report the sale accurately.

Special Considerations for Large Estates

In the case of large estates, if the estate is subject to estate taxes, the inheritance of stock might involve additional paperwork. The value of the stock on the date of death is used for tax purposes, and it is essential to ensure that the estate's value is properly calculated. This may include filing an estate tax return if the value of the estate exceeds the federal exemption limit.

Using Brokerage Firms to Track Capital Gains

Many brokerage firms provide helpful tools and reports that can assist you in tracking your inherited stock and calculating capital gains. They can help you by providing a record of the stock's value on the date of death and any subsequent transactions. Brokerage firms can also offer advice on how to handle the taxation of inherited stock.

Obtain Records from the Broker

If you don't already have the documentation of the inherited stock's fair market value at the time of death, contact the brokerage firm to obtain the necessary records. Most brokers will provide this information to help you track the stock's capital gains accurately.

Online Tools

Many online tools and financial software programs allow you to track investments and monitor capital gains. Some of these tools can help you calculate your cost basis and track the gains and losses over time. These tools are particularly useful if you inherit multiple stocks and need to manage various transactions and cost bases.

Common Mistakes to Avoid When Tracking Capital Gains

When tracking capital gains on inherited stock, there are several mistakes you should avoid to ensure you remain compliant with tax laws.

Failing to Track the Step-Up in Basis

One of the most common mistakes is forgetting to apply the step-up in basis. If you mistakenly use the original purchase price of the stock instead of the fair market value on the date of death, you could overstate your capital gains and pay more in taxes than necessary.

Not Keeping Good Records

Without accurate records of your inherited stock, you may find it difficult to calculate capital gains correctly. Keep all documents related to the inheritance, including the date of death, the fair market value on that date, and any subsequent changes to the stock, such as stock splits or dividends.

Overlooking Estate-Related Costs

Sometimes, the cost basis of inherited stock can be impacted by legal or executor fees related to the estate. These costs should be tracked and included when calculating your capital gains to avoid overpaying taxes.

Conclusion

Tracking capital gains on inherited stock requires careful attention to detail, from determining the fair market value at the time of death to keeping accurate records of all transactions. By following the proper procedures, understanding the step-up in basis, and working with your brokerage firm or tax professional, you can ensure that you are not overpaying on taxes. Furthermore, tracking your inherited stock properly will help you make informed decisions when it comes to selling or managing the assets, ultimately allowing you to retain as much value as possible from the inheritance.

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