Nobody likes to pay taxes. If done incorrectly, though, the way you inherit an asset can result in you needlessly paying tens of thousands of dollars in taxes. Knowing some simple rules will reduce your tax bill and allow you to keep more of what you inherit. And it will also keep you from creating tax headaches for loved ones to whom you wish to gift assets.



Whenever an asset is sold, Uncle Sam wants to collect capital gains tax. And that tax is figured using cost basis. Cost basis refers to how much money you invested in a given asset. When sold, the cost basis is subtracted from the amount received to determine the gain or loss. Your amount of gain or loss then determines how much you will pay in capital gains tax.

If you buy an asset for $10,000 and sell it for $25,000, your cost basis is $10,000 and the taxable gain is $15,000. Currently, the highest capital gains tax rate is 15%, which means you'd owe capital gains tax of $2,250. Losses can be used to offset other gains, but we won't get into that in this article.

Determining the cost basis can get complicated. If you buy an asset and add money to it, your cost basis increases. If it's a mutual fund and you have the dividends reinvested, that adds to your cost basis. If you sell a portion, that affects your cost basis as well. This means that it is important to keep track of the amounts you paid and received on all of your assets.

An asset can be many things, not only stocks and bonds but also houses, property, jewelry, coins, artwork, etc. Legally, you are required to pay capital gains tax whenever an asset is sold at a profit. In fact, 1099's are issued whenever investments like real estate, stocks, bonds, and mutual funds are sold.

Here's where people lose thousands of dollars. If someone gives you an asset, you 'inherit' the giver's cost basis in that asset. So if mom gives you $10,000 of stock that she's owned for years, you inherit her cost basis and are responsible for paying the capital gains tax on it when you sell it. If she only paid $1,000 for that stock and you sell it for $10,000 then you will owe taxes on the $9,000 gain.

On the other hand, let's say you inherited that stock from mom after her death (through her estate). Then your cost-basis would be the stock's market value at that time. This is called 'stepped-up basis'. So, even if mom only paid $1,000 for the stock, if it is valued at $10,000 when you inherit it you can sell it and not owe any capital gains tax. You just legally avoided the Tax Man!

This stepped-up basis is the government's way of making up for people having to pay taxes on the transfer of their wealth. But estate tax laws are in a state of flux. Under current regulation, the stepped-up basis disappears in 2011. However, there's some talk in Congress of doing away with stepped-up basis altogether, especially since the death tax only affects estates that are larger than $1,500,000. Most likely, if Congress ends the estate tax for all but the largest estates, they will collect revenues from smaller estates by abolishing stepped-up basis.

There are situations where it is better to have an asset given to you instead of it being inherited. It all depends on the size of the estate. Death taxes range from 37% to 50%, while capital gains tax rates are capped at 15%. So if an estate is going to be worth less than $1,500,000 then there will be less tax paid by inheriting an appreciated asset through the estate. If an estate will be worth more than $1,500,000 then less tax will be paid on that appreciated asset if gifted to you prior to death.

I'll provide several examples in my next article that will clearly illustrate real-life situations. That way, you will be able to more easily determine which course of action you should take and can save thousands of dollars in the process! There's no reason to pay tax when you don't have to!