Q:

Kerry;

Wow, we never realized my daughter would inherit the cost basis of my dad on the stock. Since it started out at $200 and is now around $10,000 that makes a difference. Since we keep her income below the amount that she needs to file a return (I believe it  is $4,800?) would we have to file a return if she cashes in only amounts that keep her under that $4,800?  If we cashed out part now and then  part in January 2006 would that work?  She has currently earned $1,800 from working for our company and was going to have a job this summer. Perhaps her tax basis will be low enough that the amount she would be taxed would be minimal anyway.

We always enjoy reading your newsletter each morning and saw our question in there. Reading other peoples questions and your answers is always a great education tool for us.

Thank-you;

A:

That is the big difference between receiving appreciated assets via gift versus via inheritance.  With an inheritance, the heir's cost basis is stepped up to the asset's fair market value as of the date of death.  This effectively wipes out the decedent's capital gain; although it could result in estate tax if there is a large enough taxable estate.

The standard deduction for 2005 is an even $5,000, so if she has less total gross income than that for this year, she won't be required to file a 1040.  Filing a tax return is a bit of a hassle and expense; but it still may make sense if she needs to sell off more than $3,200 worth of the stock.  Odds are that her effective tax rate will be much lower than it is for your parents, such as 5% instead of the 15% they would probably owe for Federal income tax.

As you should have noticed in many of my other postings, I have always believed it to be a big mistake to hold onto stocks just based on the tax effects.  Hold or sell decisions should be purely based on whether that stock is a good investment.  If is looks like it has peaked and is about to dive, it would be nuts to hold onto it just to avoid going over the $5,000 income threshold.  The 5% taxes saved will be small compared to the actual dollar loss in the stocks.

As you noticed, I do use these emails as an educational tool for my readers.  One point that may not apply in your daughter's case, but I have seen in others.  The $5,000 income level for a tax return filing requirement is based on the gross income, not the net profit.  This is a big mistake I have seen many people make.  They may sell stock for $50,000 that has a cost basis of $49,000, or more often, more than the $50,000.  Assuming that the tiny net gain or net loss isn't enough to warrant filing a 1040, they don't. 

What eventually happens is that IRS receives the 1099-B from the stockbroker showing $50,000 of stock sales.  When they don't see a tax return reporting this, IRS computers spit out a letter claiming that there was unreported income, along with a bill for taxes, interest and penalties on $50,000 of ordinary income.  Unless a taxpayer tells them otherwise by filing a tax return with Schedule D, IRS literally assumes that the stock had a zero cost basis and that it was owned for less than 12 months, subjecting it to ordinary tax rates rather than the lower long term capital gain rates. As I constantly emphasize, filing tax returns, even when there may be no tax effect, is a self defense measure that can head off problems such as this.

I hope this helps your family work out the best game plan.  Let me know if you have any other questions.

Kerry

 

- posted by Kerry M. Kerstetter, MBA~CPA~ATP~ATA @ 5/21/2005 03:29:00 PM Send this post: