Inherited stock and capital gains

Aug. 1, 2005
My father died several years ago, leaving my sister and me stock in a joint account worth $40,000.

My father died several years ago, leaving my sister and me stock in a joint account worth $40,000. Last year, my sister died when the stock was worth $80,000. I later sold all of this stock for $90,000. How much profit do I report, and will it qualify for long-term capital gain treatment?

Your basis in the stock is $60,000 (one-half of the $40,000 value at your father’s date of death and one-half of the $80,000 value at your sister’s date of death). Accordingly, your gain on the transaction is $30,000.

As a general rule, shares of stock must be held for more than one year in order to qualify for the 15 percent maximum tax rate on long-term capital gains. However, an exception applies for inherited stock. In this situation, all of the gain qualifies for favorable long-term treatment, even if you owned your sister’s shares for one year or less prior to selling them.

My mother went into a nursing home last year for the care of a chronic condition, and I have been paying her expenses. If I provide more than half of her support, can I deduct the medical and nursing charges? What about the cost of meals and lodging?

As a general rule, the portion of nursing home expenses allocable to medical and nursing charges are deductible as a medical expense under Section 213 of the Internal Revenue Code. In addition, the cost of meals and lodging can be deductible if you can show that your mother is in the nursing home primarily to receive treatment for a specific illness. Also, if you can prove that a doctor recommended the move and that her condition is being alleviated, your case for deductibility is even stronger.

I was planning to incorporate my practice (which netted $300,000 last year) in July and begin operating as a Subchapter S corporation. My CPA recommended I defer the incorporation until January 1 to save on payroll taxes. What is he talking about?

In 2005, only the first $90,000 of income is subject to Social Security tax. Assuming that you record $150,000 of profits during the first six months of the year, you will end up paying the maximum self-employment (Social Security) tax personally.

When you incorporate, the Social Security tax meter begins to run again. If you earn $150,000 in the second half of this year, you will also be responsible for paying the maximum Social Security taxes on your corporate salary. That’s 7.65 percent on the employer portion and the same rate for the employee portion.

While the Social Security taxes withheld from your corporate pay can be claimed as a tax credit on your current year’s personal return to avoid duplication, such is not the case with the payroll taxes paid by your corporation. That amount, representing $6,885 ($90,000 x .0765), cannot be recovered, meaning you pay duplicate payroll taxes in the year of incorporation. By deferring incorporation to January 1 of 2006, these excess payroll taxes can be avoided.

I am getting ready to sell some investment property which has appreciated more than 50 percent since I bought it two years ago. Is there any way I can avoid paying federal income taxes on the gain from the sale?

Yes. You can defer the income taxes related to the gain by entering into a tax-free exchange for other real estate, as sanctioned under Section 1031 of the Internal Revenue Code. However, you must follow many rules to qualify for tax-free exchange treatment.

To defer the entire tax on the gain, you must reinvest all of the cash received from the sale of the property and other real estate. Moreover, the cash must be deposited temporarily with an independent escrow agent (qualified intermediary), who holds the money until you acquire other investment real estate to purchase. Any cash which you actually receive from the escrow agent will be taxed to you.

You generally have 45 days from the sale date to identify replacement property to be purchased, and 180 days following the sale to close on the replacement property. Typically, the cost of the replacement property must equal or exceed the sales price of the investment property sold to avoid all taxes.

Section 1031 is not a permanent exemption from income tax, but rather a deferral of income taxes. Should the replacement property be sold at a later date, the original gain will be subject to tax, unless you enter into another tax-free exchange. However, in the event that you die while you own the property, all previously deferred income taxes on the gain will be forgiven.

John K. McGill is a tax attorney, CPA, and MBA, and is the editor of The McGill Advisory, a monthly newsletter helping dentists to maximize profitability, slash taxes, and protect assets. The newsletter ($199 a year) and consulting information are available from John K. McGill and Company, 2810 Coliseum Centre Drive, Suite 360, Charlotte, NC 28217. Call (704) 424-9780, or visit the Web site at

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