How Is Cost Basis Calculated on an Inherited Asset?

You have some options in deciding its fair market value

The cost basis calculation for inherited assets helps determine the taxes owed in states with an inheritance tax. In reality, the vast majority of estates are too small to be charged the federal estate tax, which applies only if the deceased person's assets are worth $12.06 million in 2021, or $12.92 million in 2023.

Many states do not have an estate tax—levied on the estate itself—and many others do not have an inheritance tax, which is assessed against those who receive an inheritance from an estate.

However, a handful of states—Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania—still tax a portion of inherited assets from a deceased person's estate, while a dozen states plus the District of Columbia continue to tax estates. Maryland collects both.

Whether an inheritance will be taxed and at what rate depends on a few factors, including the asset's value and your relationship to the deceased. For tax purposes, the value of the assets is calculated based on what's known as its cost basis.

Key Takeaways

  • There's rarely a federal tax on inheritances, but six states tax them based on the cost-basis value of the assets received.
  • The cost-basis figure is usually the fair market value when the estate owner dies or when the assets are transferred.
  • If the assets dropped in value after you inherited them, you might instead choose a valuation date of six months after the date of death.
  • Surviving spouses do not pay inheritance taxes; direct descendants rarely do so.

Determining Cost Basis on an Inheritance

Cost-basis calculations for estates differ from those used for other tax purposes. When used to calculate capital gains on assets you own, cost basis represents the original value of an asset for tax purposes, with a few adjustments.

Fair Market Value

With assets you inherit, the cost basis is usually equal to the fair market value (FMV) of the property or asset at the time of the decedent's death or when the actual transfer of assets was made.

Fair market value is the price that property or an asset would command in the marketplace, given that there are buyers and sellers who know about the asset and that a reasonable period of time is made available for the transaction to take place.

Alternative Valuation Date

If the value of the assets has dropped since the date of death or their transfer, the estate administrator can decide to use an alternate valuation date for the estate. This extends the valuation to six months after the date of death. Such a delay can serve to reduce the tax due on the inheritance.

You're able to wait to find out if such a reduction occurs since you can select the alternative valuation as late as a year after the relevant tax return is due. Indeed, under estate law, the estate's value must have dropped in value by the six-month mark to choose this option; otherwise, one of the regular valuation dates must apply.

Although both estate and inheritance taxes are often called "death taxes," there are distinct differences between the two. An estate tax is levied on the value of the decedent's estate (all real and financial assets). In contrast, an inheritance tax is levied on the value of the inheritance from the decedent to a beneficiary.

Which Valuation Date to Choose

A few potential disadvantages apply if you opt for the alternative date. For one, the timing must apply to all of the inheritance; you cannot pick and choose its application to particular assets. Also, the lower valuation it creates will form the basis for any capital gains you incur in the future. You may, then, eventually be subject to a larger tax bill for capital gains than if you had chosen a higher valuation when you inherited the assets.

Some exceptions to these valuation rules may apply to assets related to farming or a closely held business. It's essential to research the valuation rules before deciding when and how to carry out a valuation.

Capital Gains on Inherited Assets Sold

If you choose to sell assets you inherited, you do not escape tax liability. However, if you sell them quickly, you're subject to more favorable treatment for capital gains than is customary. No matter how long property or assets are actually held, either by the decedent or the inheriting party, inherited property is considered to have a holding period greater than one year.

Because of that, capital gains or losses are designated as long-term capital gains or losses for tax purposes. Even if you sell them immediately, you avoid the less favorable treatment typically given to assets that are held for less than a year, which are usually taxed at your normal income tax rate.

Inheritance Tax Exemptions

Even in states with an inheritance tax, family members are typically spared from tax, particularly if it's a relatively small inheritance. Surviving spouses are exempt from inheritance tax in all six states that have this tax. Domestic partners, too, are exempt in New Jersey. Descendants pay no inheritance tax in these states, either, except in Nebraska and Pennsylvania.

Inheritance Tax Threshold

The thresholds at which inheritance tax kicks in and the rates charged typically vary by relationship to the decedent. Threshold amounts vary between $500 and $40,000, and the tax rates range between 1% and 18%. The specific rules in each state can be complex. However, the stronger the familial relationship with the decedent, the less likely you'll pay a tax, and the lower the rate.

The thresholds are for each individual beneficiary, and the beneficiary must pay the tax. Bear in mind that taxation applies only to the amount of the inheritance that exceeds the exemption.

Inheritance Tax Example

For example, a state may charge a 13% tax on an inheritance greater than $10,000. Therefore, if your friend leaves you $25,000 in their will, you only pay tax on $15,000 ($25,000 - $10,000) for a bill of $1,950 ($15,000 × 0.13). You'd be required to report this information on a state inheritance tax form.

Article Sources
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  2. Internal Revenue Service. "Estate Tax."

  3. Tax Foundation. "Does Your State Have an Estate or Inheritance Tax?"

  4. Internal Revenue Service. "Topic No. 703 Basis of Assets."

  5. Internal Revenue Service. "Instructions for Form 706: Line 1. Alternate Valuation."

  6. JRC Insurance Group. "States With an Inheritance Tax (Recently Updated for 2023)."

  7. Internal Revenue Service. "Publication 551, Basis of Assets: Appreciated Property."

  8. Internal Revenue Service. "Publication 561, Determining the Value of Donated Property: Fair Market Value."

  9. Internal Revenue Service. "Publication 551, Basis of Assets: Farm or Closely Held Business."

  10. Internal Revenue Service. "Publication 544, Sales and Other Dispositions of Assets: Holding Period."

  11. Internal Revenue Service. "Topic No. 409 Capital Gains and Losses."

  12. New Jersey Department of Treasury. "Inheritance Tax Beneficiary Classes."

  13. New Jersey Department of Treasury. "Inheritance Tax Rates."

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