One of the differences of opinion I run into with clients that puzzles me most is their attachment to particular investments. This often occurs when children inherit an investment portfolio from their parents and want to keep the stocks that contributed significantly to their parents’ wealth.
In one case where I was co-trustee of a trust, after the mother died we sold her stock holdings and invested the proceeds in a more diversified portfolio. This incensed her daughter who ultimately talked us into buying back a particular holding to which she had a strong emotional attachment.
For the parents, holding investments long-term can make a lot of sense. First, it’s often a good investment strategy to buy and hold rather than trading stocks all the time. But often more important, if they were to sell the shares they would likely incur substantial taxes on capital gain.
The Step-Up in Basis
For their heirs, however, this second motivation for holding onto stock disappears due to the step-up in basis that occurs upon the death of their owner. To explain, capital gain is the difference between the proceeds of the sale of stock and its tax basis. The basis is the purchase price. (This is also true for other assets, such as real estate or artwork, but in the case of real estate there may be certain adjustments.) So, if you bought a share of stock for $10 and sold it for $100, you would realize $90 in capital gain.
The federal tax on capital gain ranges from 0% to 20% depending on the seller’s income, but for most taxpayers it’s 15%. Their state may also assess a tax. So, on the sale of our share of stock with $90 of gain, the tax is likely to be $13.50 or higher, not terrible, but no one wants to pay taxes if they can be avoided.
The best way to avoid the tax is to pass the property to your heirs because upon your death the basis is adjusted to its value on your date of death, the so-called “step-up” in basis. So, again returning to our share of stock, if upon your death it’s fair market value is $100, that will be it’s new basis. If your heirs sell the stock at that price they will realize no capital gain and pay no tax, thus saving the $13.50 or more.
Investment Strategy
While it’s usually good investment strategy to buy and hold stocks, financial advisors also usually advise clients to diversify their investments. The stock portfolio that did well for the parents likely holds a lot of shares in a relatively few companies since it’s the past increase in value of these holdings that contributed to the success of parent’s investment strategy. But as investment companies keep telling us “past performance does not guarantee future results.” A safer investment approach is to diversify the portfolio among a wide selection of stocks or index funds. This is less likely to produce outstanding results that do better than average market returns, but also less likely to produce results that trail the market.
Efficiency of Estate Administration
I often get questions on my AskHarry.info website about whether estate or trust stock holdings should be liquidated so that the personal representative or trustee can distribute cash or instead that the shares of stock be divvied up among the heirs. I almost always advise liquidating the portfolio because it’s so much easier to distribute the proceeds than splitting up investments. The cash can easily be sent by check or wired into the accounts of the various heirs.
To divide up the stock portfolio, the heirs usually have to set up accounts at the same investment firm where the deceased individual held their investments. Investment advisors often recommend this approach as a way to develop relationships with the heirs. Unfortunately, we’ve had instances in our office where a single heir’s failure to follow through and set up their account has delayed distributions for all the heirs. In part, this has to do with the necessity of distributing shares of stock at the same time for all beneficiaries. Otherwise, their fluctuating market value can raise questions as to whether everyone has received an equal distribution.
Delays almost inevitably increase the cost of estate administration due to increased legal and accounting fees, especially if the delay means that the final estate or trust tax return will not be filed until an additional year has passed. As a result, simply liquidating the investments and distributing the proceeds often saves estates money in the long run. Due to the stepped-up basis, it rarely results in significant taxes on capital gain.