How is cost basis calculated on an inherited asset?

An inheritance tax is a tax that may be imposed on a person who inherits the estate of a deceased person. The rate at which the inheritance is taxed depends on the value of the inheritance and the relationship of the beneficiary to the person who passed away.

Generally, when property or other assets are inherited, the cost basis is usually equal to the fair market value of the property or asset at the time of the decedent's death or time of actual transfer. Fair market value is the price that a property or asset would command in the marketplace, given that there are buyers and sellers knowledgeable about the asset and that a reasonable period of time is made available for the transaction to take place.

If the administrator of the estate votes to use an alternate valuation date for the estate, the inheriting party must be notified. The cost basis is then equal to the fair market value of the property or assets either six months following the date of death or the date on which the asset was distributed to the person inheriting it, whichever is earlier. For assets related to farming or in a closely-held business there may be some exceptions to check further into.

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. Thus, capital gains or losses are designated as long-term capital gains or losses. Under current tax law, long-term capital gains are taxed at a more favorable, lower rate than the normal income tax rate.

In contrast to the cost basis for inherited assets, assets that are received as gifts usually retain the giver’s original cost basis. Financial advisors note that gifted stocks can be a source of confusion in regard to determining cost basis, as it is essential for the receiving party to know the original price that the giver paid for the stock, which may have been purchased either long ago or in increments over a span of time, at different share prices.

(For more, read "The Tax Implications of Inheriting Assets.")