David R. Evanson
Privately Published, Spring, 2004
Markets change over time. Industries come and go, companies come and go and so too do the people around us. But when friends and relatives pass on, it can have an impact on our financial picture, especially when we inherent assets they leave behind, or if we owned assets with them.
The most immediate change in jointly owned or inherited assets after someone dies is that the basis [italicize basis] changes. As you may recall from previous TIPS, the basis of an investment is simply the cost to the investor. An investor who purchases 100 shares of the T. Rowe Price Equity Income Fund for $20 per share has a cost basis of $2,000 (100 shares x $20 per share). This basis will be used to calculate the investor’s gain or loss when they sell the shares, and as a result has an impact on the taxes they pay, and the overall return they earn.
Let’s first take a look at how to determine the basis for assets you inherit.
This is very easy. Your cost basis is the total value of the securities on the date of the person’s death. When you ultimately receive the securities, make sure the executor clarifies this cost basis for you in writing.
As an example, suppose your grandmother purchased 1000 shares of the T. Rowe Price Equity Income Fund for $1,000. Further assume they are worth $2,000 the day she passes away and you inherit them. Your basis is $2,000. The federal government forgoes the taxes on the growth and you get a fresh start at the new, ‘stepped-up’ basis.
If you sold these shares immediately, there would be little or no taxes due. If you sell the shares three years later when, hypothetically, they are worth $2,500, you will owe capital gains taxes on $500 ($2,500 sales price – $2,000 basis).
Our example assumes the value of the shares the day your grandmother dies – sometimes called the ‘alternative valuation date’ – is higher than what she paid for them. Let’s assume that she paid $3,000 for shares in a mutual fund, and they are worth $2,000 on the date of her death. Now what?
The basis depends on the value of the securities when you sell them. If you sell them for less [italicize less] than $2,000, your cost basis becomes $2,000 – and your capital loss is $2,000 minus whatever you sell the shares for. If you sell them for anything between $2,000 and $3,000, the IRS says that you have neither a gain nor a loss, and no taxes are owed when you sell.
Obviously, it’s better for heirs to receive appreciated assets. Accordingly, as you consider your own estate planning, or as you discuss planning with others who are leaving assets behind for you, it’s important to consider whether or not these assets will be held until death. If you or your relatives wish distribute wealth before your death, but also wish to retain control of the assets, it may be better to give gifts of cash and preserve financial instruments such as stocks, bonds and mutual funds until after death. Under this arrangement, beneficiaries will likely receive stocks, bonds and mutual funds at a ‘stepped up’ basis, which will lower their overall tax liability, if and when they sell these securities.
Now let’s examine what happens when you own securities jointly with someone and they die.
First, if the person who owns the securities with you is not [italicize not] your spouse, the new cost basis equal to the value of the securities on the date of death. So if you and your sister originally purchased $1,200 of shares the T. Rowe Price Equity Income Fund that are now worth $2,000, and your sister passes away, your new cost basis for all of the shares is $2,000.
If, on the other hand, the person who owns the shares with you is [italicize is] your spouse, the new basis depends on what state you live in. If you live in a so called community property state, the cost basis works the same way illustrated above.
If you live in what is known as a non-community property state, only shares of the other joint owner are adjusted. Assume you and your spouse jointly own 1,000 shares – 500 each – of the T. Rowe Price Equity Income Fund that you purchased for $12.00 per share, or $1,200. Further assume that your spouse passes away and on the date of his or her death, the shares are worth $2,000 or $20.00 per share. Your half retains the original basis of $600. The other half, which belonged to your spouse, are assigned a basis of $1,000 (500 shares x $20.00 per share on the date of death). The sum of the two, $1,600 ($600 original basis for your half + $1,000 new basis for your spouse’s half) is your new basis.
Investing with T. Rowe Price can make your life easier. Be sure to let us know the cost basis of any shares you inherit so that going forward, we can track average cost basis for you, which includes the effect of additional purchases and reinvested dividends. We include the cost basis information on Form 1099-B (mailed in January) for your convenience, but we do not report the cost basis to the IRS.