As a general rule, inherited assets are received income tax free. The primary exception is “income in respect of a decedent,” or “IRD.” Income in respect of a decedent is income earned by a decedent before death, but not paid until after death (IRD is discussed in greater detail in Chapter Six: “IRA and Retirement Distributions” and Chapter Eight: “Tax Reporting”). Examples of IRD include bond interest, deferred compensation, you spouse’s last pay check, IRAs, 401(k)s, and other retirement plan distributions. Items of IRD are taxed at your personal income tax rate in the year received.

In addition to being tax-free upon receipt, inherited assets receive a “stepped up” basis. Basis is the mechanism used in tax law to measure gain or loss when an asset is sold. Basis is a person’s investment in an asset, usually its purchase price. A step-up in basis is essentially a forgiveness of pre-death appreciation, allowing inherited assets to be sold income tax free. For example, if Harry paid $10,000 for a stock, his basis is $10,000. If he later sells the stock for $20,000, his gain is $10,000 ( $20,000 sale price less his $10,000 basis ).

If, rather than selling the stock, Harry left it in trust to his wife, Wendy, she can sell the stock immediately after Harry’s death and pay no tax. Wendy’s pays no tax because her basis is the fair market value of the stock on the date of Harry’s death. If Wendy waits a year and sells the stock when it has increased in value to $30,000, her gain is $10,000 ($30,000 sales price less $20,000 basis). To substantiate your new basis, it is extremely important that you document the value of your late spouse’s assets as of the date of death. The Asset Inventory With Values Worksheet will help you record the date-of-death value of all assets.

A full step-up in basis occurs when an asset is held solely in the name of the decedent. Different rules apply where assets are held jointly between a husband and wife. If the joint tenant is the decedent’s spouse, the surviving spouse receives a stepped-up basis on only one-half of the value of the asset. For example, if Harry and Wendy paid $10,000 for the stock and owned it jointly at the time of Harry’s death, Wendy’s new basis would be $15,000 (her $5,000 share of the original purchase price, plus Harry’s $10,000 stepped up basis on his half). This rule applies no matter which spouse supplied the funds to acquire the asset.

The Economic Growth and Tax Reconciliation Act of 2001 (“Act”) eliminates the federal estate tax effective in the year 2010. The Act eliminates the stepped-up basis effective in 2011. Interestingly, the Act contains a “sunset” provision, requiring Congress to ratify full repeal in 2010. Unless Congress, in 2010, again votes to repeal the estate tax, both the estate tax and the stepped-up basis are retained. The delayed effective date of the Act and the sunset provision make it difficult to plan. You cannot be confident that either the estate tax or the stepped-up basis are a thing of the past. The solution is to keep good records and be prepared for any and all eventuality.