When wealth transfers from one generation to another often times there’s an opportunity for mistakes to be made, especially when passing appreciated non-retirement assets. In the last six months we’ve come across two separate cases in which an error could’ve cost these families well over $500,000 in unnecessary taxable gains, and it was of no fault of their own.

Non-retirement also known as non-qualified assets such as stocks, bonds, mutual funds, and real estate receive special tax treatment when passed from one generation to the next. Generally speaking if you inherit an asset like these that have appreciated in value you get an automatic step up in basis.

What’s “basis” mean you ask? The basis of an investment is the dollar amount the owner paid for the asset. For example, I purchase 1,000 shares of XYZ company for $50. My basis in the investment is $50,000.

Gain above basis is taxable. If you’ve held the asset for 12 months or longer you pay long-term capital gains rates, and if you’ve held the asset for less than 12 months you generally pay short term capital gains.

Let’s say for example your mom has non-retirement assets in a brokerage account made up of stocks and bonds. The portfolio started out with $100,000, and it is now worth $500,000. Each individual asset inside of the portfolio will have a specific price that was paid to purchase the asset. That price is the cost basis. Any market value gain above that price is taxable to the owner, your mom. 

Mom owns 1,000 shares of company ABC and the current market value of 1 share is $500.  Her total shares are worth $500,000. Now let’s assume she paid $100 per share for company ABC 10 years ago.  Her cost basis on the shares is $100,000. Her gain above basis is $400,000. Since she has held the shares longer than 12 months she would incur Long Term Capital Gains if she sold some the shares. She would owe taxes, likely at a 15% rate depending on her income tax bracket. 

What if mom never sells the shares? She instead dies with them, and you inherit the 1,000 shares of company XYZ worth $500,000? Now you have to pay taxes on the $400,000 of gain, right?

WRONG! At her death, her property (stock in this example) receives a step up in basis to the market value as of the date of her death. You inherited $500,000 of company ABC stock and your new basis is $500,000, or $500 per share. It is important for the owner of the assets and her heirs to understand the difference and how the tax code works.

As you can see, for those nearing the end of life selling highly appreciated assets (like company stock or real-estate) may be a big mistake. This is especially true if the intention is to pass the wealth to the next generation. It may be better for everyone involved to hold onto the appreciated asset and allow the heirs to receive it with a stepped-up basis at death.

Does the step up automatically occur?

Well, legally yes. The tax code states that the asset receives a stepped-up basis treatment. However, who’s watching to make sure this happens? Who reports it to the IRS?

The financial institutions holding the assets are responsible for reporting the tax status to the IRS. However, it’s up to the heirs to report the death, and provide a death certificate in order to adjust the basis. Even then, it is not a sure thing that the institution will get it right.

What we’ve discovered is that the financial institutions holding the assets are not always diligent about tracking, and reporting basis accurately. In fact, the misreporting of cost basis is happening more often than I would have ever imagined.

Case in point. One of my clients came to me with large brokerage account. It was worth over $500,000. She had opened the account in 2017. However, her cost basis on the investments within the account was $300,000. Had her investments really grown by 74% in less than 18 months? Not likely. Something was fishy!

However, when explained to me how she had acquired the assets the pieces began to make sense.

When her mother passed in early 2017 the assets were divided up between three siblings. Our client, her sister, and her brother all received a third of her mother’s non-qualified brokerage account. They each opened a new account at the same financial institution where their mother’s account had been held. Their shares of mom’s assets were transferred in-kind to each of their individual accounts.

(Record scratch) What’s “in-kind” mean you ask? It means nothing was bought or sold. The investment shares transferred over, rather being liquidated to cash. My client had inherited property, in this case stock.

Mom’s assets had appreciated 74% since the basis was set. Had she liquidated it prior to her passing she would have owed significant capital gains tax on the sale. However, since she passed the property at her death the market value of approximately $1,500,000 would become the new basis, and her children would avoid capital gains taxes on over a $600,000 of appreciated value. That is if the financial institution reported the step up in basis.…but they didn’t’!

Why hadn’t the financial institution recognized the inheritance of property? Why hadn’t they stepped up the basis when transferring assets in-kind into the newly established accounts for the kids? Why didn’t the advisor, appointed by the financial institution, working on my client’s case recognize the error? Why hadn’t he taken actions to correct it?

Rest assured, we were able to correct the error for our client and her sibling, but what could have happened if we’d not been introduced? Had error gone undetected it is likely she would have sold some of the stock positions to put a down payment on a house. The sale of the stock would have been report as a gain, and she could have ended up paying unnecessary capital gains taxes.

Financial institutions are not perfect. They make mistakes. Everyone does from time to time.

On the other hand, it seems to be a rampant issue. It seems like there’s not a big concern on the part of the financial institutions to keep track of these details.

Errors like this if left unchecked could result in taxable distributions of capital gains worth tens of thousands, if not hundreds of thousands of dollars depending on the size of the inheritance. It’s absolutely critical that we spot check the financial institutions and then work with them on your behalf to accurately report gains and losses on investable assets.  

Review an inheritance you’ve received to make sure that you don’t unnecessarily pay more in taxes than what you are legally required to pay.

“Investment Adviser Representative of and advisory services offered through Royal Fund Management, LLC, a SEC registered investment adviser.”

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