Gifting and Inheriting Investments: Step-Up in Basis and Gift Tax

Two investors can hold the same shares of the same fund and face very different tax bills depending on how those shares reached them. If you bought them, your cost is your purchase price. If they were given to you, you usually inherit the giver's cost. If you inherited them at death, your cost is usually reset to the market value on that date. Understanding that difference, and the filing rules around gifts, can prevent surprises. This article is general information for the United States; estates are individual, and the details deserve a professional's review.

First, a reminder of basis

Cost basis is the starting number used to calculate your gain or loss when you sell. Sell above basis and you have a capital gain; sell below it and you have a loss. The cost basis guide explains how it is calculated and reported, and the capital gains overview covers short-term versus long-term rates. The rules below change only how basis is set when an asset changes hands without a purchase.

When you receive a gift: carryover basis

If someone gives you appreciated stock while they are alive, you generally take over their basis. This is called carryover basis. The gift itself is not taxable income to you. The built-up gain moves with the asset, and you pay tax on it when you eventually sell.

Example, in plain terms: a parent bought shares for a low price years ago and gives them to their adult child when they are worth much more. The child's basis is the parent's low original cost, not the value on the day of the gift. If the child sells, the gain is measured from that original cost.

Two details matter:

• Holding period carries over too. The giver's time holding the asset generally counts toward whether your gain is long-term or short-term.
• There is a special rule for losses. If the asset was worth less than the giver's basis on the date of the gift, the basis used for calculating a loss can be the lower market value, while the giver's basis is used to calculate a gain. The result is that a gifted loss can be lost: a sale between the two figures may produce neither gain nor loss. Keep the giver's records and the value on the date of the gift.

Because carryover basis passes along the tax bill, gifting highly appreciated stock is not automatically tax-free in effect. It moves who pays and when. It can still make sense if the recipient pays a lower tax rate, but compare that with the inheritance route below.

When you inherit: the step-up in basis

At death, most assets held outright in the deceased person's name get a new basis equal to their fair market value on the date of death. This is the step-up in basis. In many cases, it wipes out the unrealized gain that accumulated during their lifetime for income tax purposes. If the assets had fallen below the owner's cost, the basis is stepped down to the lower value.

Key points:

• The heir sells at little or no gain if they sell soon after inheriting, because the basis equals the value at death.
• Holding period is treated as long-term for inherited assets, regardless of how long the heir actually held them.
• The estate may use an alternate valuation date in some situations. The executor and tax preparer handle this, and it affects basis.
• Community property states can provide a step-up on both halves of property a married couple owned together, which can differ from other states. Ask a professional about your state.
• Documentation matters. Brokerages usually update basis after receiving a death certificate and estate paperwork, but it's worth checking the figures against statements from the date of death.

Step-up is a rule about capital gains on income tax. It doesn't eliminate federal estate tax or any state estate or inheritance tax, which are separate regimes with their own thresholds. The federal estate tax exemption is set by law and adjusted periodically, so check the current figure at irs.gov rather than relying on a number quoted elsewhere.

What doesn't get a step-up

Not everything an heir receives resets:

• Traditional IRAs, 401(k)s and similar accounts are not stepped up. Withdrawals are generally taxed as ordinary income, and inherited-account distribution rules apply. See the inherited IRA rules explainer.
• Annuity gains and other income that the owner had earned but not yet been taxed on can still be taxable income to the heir.
• Assets given away before death keep carryover basis, even if the giver dies soon after. Gifting a highly appreciated stock to a parent, who then leaves it back to you, is the kind of maneuver tax rules address, so don't try to engineer it without advice.

Gift tax: who files and when

The federal gift tax is easy to misunderstand because it rarely produces a bill.

• The giver, not the recipient, is responsible. The recipient does not report a gift as income.
• The annual exclusion allows a gift up to a set amount per recipient each year without any filing. The IRS publishes the figure annually.
• Gifts above the exclusion generally require the giver to file Form 709, a gift tax return. Filing reduces the giver's lifetime exemption, but usually no tax is due until that large lifetime amount is used up.
• Spouses who are US citizens can generally give to each other without limit. Payments of tuition or medical bills made directly to the school or provider are also treated separately.
• Value matters. Gifts of stock are valued using the market price on the date of the gift, which is also relevant for the loss rule above.

Check current exclusion and exemption figures at irs.gov. Some states have their own rules too.

Gift or inheritance? A way to think about it

Neither path is automatically better. Gifting can support a family member sooner, move future growth out of your estate and use lower tax brackets. Holding until death can eliminate income tax on gains. The right choice depends on the size of the estate, the recipient's tax situation, your own need for the assets and state taxes. A tax professional or estate attorney can model the numbers.

Practical steps

1. Keep basis records for anything you might give or leave, including purchase dates, reinvested dividends and any wash-sale adjustments.
2. If you receive a gift, ask the giver for their basis and purchase date, and record the value on the gift date.
3. If you inherit, get date-of-death valuations from the brokerage and make sure basis was updated before you sell.
4. Consider gifting cash or high-basis assets when you want to avoid passing on a built-up gain.
5. Talk to a professional before moving large positions, especially if state estate taxes or complex trusts are involved.

Start by collecting basis information while the person who knows it is still around to explain it, so the tax decisions can be made calmly.

This article is for general information and education only. It does not account for your circumstances, and it is not tax or legal advice.