How Taxes on Inherited Stocks Work, Potential Changes

As President Biden proposes significant increases in capital gains taxes, many investors are considering how to lock in the best stock returns for themselves or their heirs. When investors buy and sell stocks or other assets, they have to pay taxes on any gains from that investment. 

Currently, those who inherit stocks get a tax break compared to if the original owner gifted the stock to them while still living. The cost basis, or the value of the asset, resets to the value when the original owner acquired the stock, instead of the current market value at the time of the person’s death. 

Capital gains are the increase in value of a stock from the time of purchase to the time of sale in the future. If a stock decreases in value during the time you hold the stock, that’s a capital loss.  

Capital gains are taxed at your regular income tax rate if you hold the stock for less than one year (short-term capital gains). Those who hold a stock or other asset for longer than one year will be subject to capital gains tax rates of either 0 percent, 15 percent, or 20 percent depending on the person’s income level.  

Under current tax law, those who inherit property or stocks receive what is called a “step-up” in basis to its fair market value. As the Tax Foundation says, this “eliminates an heir’s capital gains tax liability on appreciation in the property’s value.”  

If you receive stocks as part of an inheritance, you can benefit from acquiring stocks without having to pay taxes on the investment gains realized from the date of purchase to the date of the owner’s death.  

In contrast, stocks received as a gift while the stock donor is still living are subject to capital gains taxes. Heirs must pay taxes on the value of capital gains, or the amount the stocks appreciated from the original time of purchase to the sale date.  

The current tax code makes it advantageous to inherit stock after a person’s death instead of receiving it as a gift during their lifetime. 

Part of Biden’s American Families Plan is the proposal to raise the maximum rate of capital gains taxes for households making over $1 million to 39.6 percent (up from 20 percent). He also proposes eliminating the step-up in basis, which means heirs would have to pay capital gains taxes on stocks.  

The Tax Foundation notes that this elimination would increase federal revenue and encourage capital gains tax realization.  

This would greatly increase the tax burden on those who inherit stocks or other assets, especially if the estate tax remains unchanged. “Combining the estate tax, the new higher capital gains rate and the repeal of step-up in basis could bring total effective marginal rates as high as 61%,” reported CNBC.  

Brad Sprong, KPMG partner and private enterprise tax leader, said he is telling clients to prepare for possible changes. They might want to make large gifts to loved ones now, rather than waiting, in case there's increased taxation on inheritances.