Reasoning behind the cost basis step-up
The IRS began taxing estates with the passage of the 1916 Revenue Act. This change to the tax code was primarily meant to help pay for World War I by supplementing the funds generated from income tax. However, in addition to creating a new tax to generate more revenue, lawmakers also saw a practical benefit to allowing for a stepped-up basis on inherited wealth.
As anyone who has invested for a long time can attest, keeping track of the cost basis for your stocks can be an ongoing nightmare. Keeping records of every purchase and reinvestment over time is a monumental task. When you have to rely on someone else's records dating back to before you even took ownership of the inherited stock, that task can become almost impossible. In addition, because assets in a person's estate are potentially subject to estate taxes, the basis step-up eliminates the possibility of double taxation.
Figuring out the basis
If a substantial time has passed since you inherited the stock, you'll need to find prices for the shares at the date of death. Fortunately, those prices are readily available from financial news sources and from company investor relations departments. If a tax return was filed for the estate and an alternative valuation date was chosen, those values should be used as the stepped-up basis instead.
In addition, it's important to note that if you've enrolled in an automatic dividend reinvestment plan (available via most major brokerages), you may have purchased additional shares after you inherited them. It's crucial to understand that the cost basis of the inherited shares is separate from the cost basis of the newer shares. If you fail to account properly for both sets of shares, you can end up paying more in capital gains taxes than necessary.
The cost-basis calculation should be the same whether a person inherits stock through a revocable trust or a will. The same holds true for stocks inherited through a brokerage.
Finally, keep in mind that the step-up rules apply only to property that was legally included in the deceased person's estate at death. Gifts of stock that someone gave you while they were still living don't get a step-up. Trusts on your behalf that became irrevocable prior to the death of the creator usually won't get favorable treatment either.
Nevertheless, in most situations involving inherited stock, the basis step-up rules make things a lot simpler and less costly for heirs. Just knowing the rule and using it correctly can save you thousands in unnecessary taxes.
