People may use the term “Stepped-Up Basis,” which many believe is a tax provision that allows beneficiaries of an inheritance to reduce or even avoid taxes when and if they sell inherited property.
When an individual sells property, any gain from the sale of the property is taxable. The tax term “basis” is the value from which any taxable gain is measured. For personal use property or investment property, the basis is generally the cost of the property. For business property, the term basis is replaced with an adjusted basis, which generally means the cost of the property is reduced by business deductions, such as depreciation, attributable to the property.
However, the term inherited basis is used for property received as a beneficiary. Tax law specifies that property received by a beneficiary as a result of inheritance is the property's fair market value (FMV) as of the decedent’s date of death. Since some property, such as real estate, generally appreciates over time, that means the property’s value will have increased, and the FMV on the date the decedent died will be higher than the decedent’s basis. Thus, the beneficiaries will inherit the property with a basis higher than the decedent’s, so they will have a stepped-up basis.
Example: Jack has owned a rental property for several years. He purchased it for $200,000 and, over the years, claimed a depreciation deduction of $24,000 up to the time of his death. Thus, his basis when he passed away was $176,000 ($200,000 - $24,000). At the time of Jack’s death, the rental had an appraised FMV of $400,000. Bill, Jack’s only beneficiary, will have a basis of $400,000, and if he immediately sells the rental for $400,000, he will not have a taxable gain. On the other hand, had Jack sold the property for $400,000 just before his death, he would have had a taxable gain of $224,000 ($400,000 - $176,000). (Sales expenses have been disregarded in this example.)
The example demonstrates the value of a beneficiary receiving a “stepped-up” basis. However, the actual term used in tax law is that the beneficiary receives the FMV at the date of the decedent’s death, so it is not always a stepped-up basis; there could be a step-down basis.
Another tax benefit of inheritance is that a gain from the sale of inherited property is treated as being held long-term and benefits from the lower long-term capital gain tax rates even though the beneficiary does not hold the property over one year.
Spousal Inheritances – Where spouses jointly own property, a surviving spouse will sometimes only inherit half of the property since they already owned half and thus only receive a basis adjustment on the inherited portion of a property. However, where the spouses live in a community property state, and the property is held as community property, the surviving spouse will get a basis to reset to the FMV of the property for both the deceased spouse’s half they inherited and their own half.
Jointly Owned Property – Where two or more individuals own property as joint tenants and the joint tenants inherit a portion of the property from a deceased joint tenant, the beneficiary joint tenants only receive a basis adjustment on the inherited portion of the property.
In the case of inherited business property or rentals, a frequently asked question is what becomes of the accumulated depreciation on the inherited portion of the jointly owned property? This is another benefit of inheritances, as the accumulated depreciation goes away. If using the inherited property for business purposes or as a rental, the beneficiary restarts the depreciation from scratch on the inherited portion.
Gifting Prior to Death – Another issue is that some individuals gift property before death. This is commonly encountered by elderly parents gifting a home or rental to their children. When an individual receives a gift of property, the individual’s basis becomes the same basis as the giver’s. Therefore, there is no step-up in basis as previously discussed. So, unless there is some other underlying issue, generally, it is not a good idea tax-wise to make large gifts of property.
Example: Mom is in her 80s and her home, which she purchased for $100,000, has a current value of $300,000. She gifts the home to her only child, Joe, while she is still living. For gifts, the gift recipient’s basis becomes the giver’s basis; in Mom’s case, her basis was $100,000, which becomes Joe’s basis. As a result of the gift, Joe has a $200,000 built-in gain when and if he sells the home. If Joe had inherited his Mom’s home, his basis would have been $300,000 plus any additional appreciation before her death.
As you can see, our tax laws are complicated regarding inheritances and gifts. It is generally good practice to pre-plan for inheritances and gifting. Call to book a tax planning consultation.