Capital Gains - and Possible Change - Explained

Concerns abound regarding a capital gains taxation upheaval should the approaching November election result in a change in the Washington power structure. The most prevalent concern involves “step-up” rules on capital gains (and losses) of inherited stock.

What is a Capital Gain?

A capital gain is the profit generated by the sale of an asset such as a stock, land, a business. Generally speaking this is considered taxable income. The tax rate on capital gains vary based on how long an asset has been held before selling, the seller’s income during the year of sale, and in what type of financial vehicle the gains-generating asset is held (i.e., tax-advantaged account, taxable account, etc.).

In 2020 the capital gains tax rates are either 0%, 15% or 20% for most assets held for longer than a year. For less than a year, tax rates on most assets correspond to an individual’s ordinary income tax brackets (10%, 12%, 22%, 24%, 32%, 35% or 37%). Since we’re discussing inherited stock here, the foregoing information suffices only as a clarifying prelude to our subject matter.

Tax-Advantaged Accounts

Tax-advantaged accounts include 401(k) plans, IRAs (traditional and Roth) and 529 college savings accounts where investments grow tax-free or tax-deferred. In short, you don’t have to pay capital gains tax on investment sales withinthese accounts as they occur. Roth IRAs and 529s, in particular, offer significant – tax-free – qualified distributions. That’s right, you don’t pay any taxes on such investment earnings. With traditional IRAs and 401(k)s, however, you’ll pay taxes when you receive distributions, required (i.e., RMDs) or otherwise, from those accounts.

Inherited Stock Gains

So, what is the tax on inherited stock gains? As mentioned earlier, it depends on the financial vehicle holding the gains-producing asset. But one simple fact never changes – Uncle Grabby always gets his cut, now or at some future date whether capital gains occur in a tax-deferred traditional or Roth IRA, or if a person (decedent) dies and leaves shares of stock to his or her heirs in a taxable account.

With regard to Roth IRA assets (purchased with after-tax dollars), Grabby has already taken a bite from that apple; thus, withdrawals are generally tax-free to the lucky heirs. With traditional IRA assets (purchased with pre-tax dollars) withdrawals are treated as taxable income – paid at the individual’s ordinary income tax rates, not at capital gains rates.

Taxable Accounts

For inherited stock held in non-tax-deferred accounts, a different set of rules called “step up” rules apply. In short, an heir’s cost basis in a stock is its fair market value on the date of the decedent’s death. This is a good deal for the heir, certainly better than it would have been for the original owner (decedent), had the decedent sold the asset (in this case, stock) prior to his or her untimely demise. An example:

Decedent buys a share of stock for $100 (the basis) and later sells it for $125 a share. Decedent would be taxed on the $25 gain over basis.
Decedent who paid $100 for a share of stock dies and bequeaths the share, worth $125 on the date of his or her death, to an heir. The heir’s basis of the stock “steps up” to $125. By the way, it can also “step down”.
The heir, needing money, immediately sells the inherited stock for $125. Because the heir’s basis is $125, there is no gain on the sale and no tax due.
If the heir holds the share of stock and later sells it for $150, there is a taxable gain of $25 above the heir’s “step-up” basis of $125. Any capital gain or loss that is the result of selling inherited stock is always long-term. This rule applies regardless of how long the heir or the original owner held the stock. Once passed to an heir, the decedent’s original basis of $100 has no bearing on the heir’s sale in either case.

This is a simplified explanation of capital gains taxation. A sale involving a capital gain can become complicated because of extraneous factors like income level, carry over and capital loss offsets, “collectible assets” which are generally taxed at 28%, the 3.8% net investment income tax thresholds, etc. So keep your CPA’s phone number handy. And fair warning, heirs should remain ever vigilant. The only deal Uncle Grabby really likes is one in his favor. At some point the aforementioned “step-up” deal could fall victim to an estate tax legislative reshuffling, and Grabby would be incredibly pleased.

Change is in the Air

Because of COVID-19 and/or the looming election, a reshuffling may be coming sooner than you think. Under current law, assets that pass directly to heirs benefit from the “step-up in basis”, which means the heir receives the asset valued as of the date of decedent’s death. If the heir should sell this holding quickly, he or she would pay little to no capital gains taxes.

According to the Tax Policy Center, the Democrat Presidential candidate proposes to tax an asset’s “unrealized appreciation” at transfer and at an ordinary income tax rate potentially as high as 39.6%. Such a hugely dramatic change would, of course, require Congressional approval.