Inheritance of Securities

The cost basis rules for inherited securities differ from gifted securities, and they are significantly more favorable. Understanding the stepped-up basis is essential for the exam and for making sound investment recommendations.

Stepped-Up (or Stepped-Down) Basis

When a person inherits securities from a decedent, the cost basis resets to fair market value:

• Inherited securities receive a cost basis equal to the fair market value (FMV) on the date of the decedent's death
• This is called the stepped-up basis (or stepped-down if FMV at death is lower than the decedent's original basis)
• The step-up eliminates all unrealized gains that accumulated during the decedent's lifetime
• The step-down similarly eliminates unrealized losses

Example:

• Decedent purchased stock at $20/share
• FMV at death is $100/share
• Beneficiary's cost basis: $100 (stepped-up to FMV at death)
• If beneficiary sells at $110: capital gain = $10
• The $80 of appreciation during the decedent's lifetime is never taxed

Exam Tip: Gotchas

• The basis resets to FMV at death, not the decedent's original purchase price. Decades of unrealized gains are completely eliminated.
• A stepped-down basis also exists. If the asset declined in value, the basis steps down to the lower FMV at death.

Holding Period for Inherited Securities

All inherited securities receive a special holding period treatment:

• Inherited securities are automatically treated as long-term capital assets
• This applies regardless of how long the decedent held the security
• Even if the decedent held the security for one day before death, the heir gets long-term treatment
• There is no minimum holding period for the beneficiary; they could sell the next day and still receive long-term capital gains treatment

Exam Tip: Gotchas

• Inherited securities are ALWAYS long-term, even if sold the day after inheriting. The beneficiary does not need to wait 12 months.

Alternate Valuation Date

The estate executor has a choice about which date to use for valuation:

• The executor may elect to use the alternate valuation date (6 months after death) instead of the date-of-death value
• This election may only be used if it reduces both the gross estate value and the estate tax liability
• If an asset is sold or distributed between the date of death and the alternate date, the FMV on the date of sale or distribution is used
• The election applies to all estate assets (you cannot cherry-pick individual assets)

Exam Tip: Gotchas

• The alternate valuation date can only be used if it reduces BOTH the estate value AND the estate tax. If it reduces one but not the other, the executor must use the date-of-death value.

Community Property vs. Common Law States

The step-up rules differ based on whether the state follows community property or common law:

• Community property states: Both halves of community property receive a step-up at the death of one spouse
• Common law states: Only the decedent's share receives a step-up; the surviving spouse's share retains the original basis

Think of it this way: In a community property state, when one spouse dies, the surviving spouse's half of the community property also gets a fresh basis. This can eliminate decades of unrealized gains on the entire asset, not just the decedent's share.

Exam Tip: Gotchas

• In community property states, BOTH halves get a step-up, not just the decedent's half. This is a significant tax advantage over common law states.

Gifts vs. Inheritance: Side-by-Side Comparison

Exam Tip: Gotchas

• Gifts carry over the donor's basis (and potentially the gain), while inherited securities get a fresh start at FMV. This distinction is frequently tested.
• Highly appreciated assets are often better held until death rather than gifted during life, because the step-up eliminates all prior gains.