Did you know? There’s a special tax benefit for inheritances. You may hear people use the term “Stepped-Up Basis”. This is a tax provision that can be quite beneficial to people who inherit property. It allows beneficiaries of an inheritance to reduce or even avoid taxes when selling 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 adjusted basis. All that means is the cost of the property reduced by business deductions, like depreciation, attributable to the property.
However, for property received as a beneficiary the term inherited basis used. Tax law specifies that property received by a beneficiary as a result of an inheritance is the fair market value (FMV) of the property 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. This is considered a stepped-up basis.
Example of this special tax benefit for inheritances
Jack has owned a rental property for several years. He purchased it for $200,000. Over the years, Jack 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. If he immediately sells the rental for $400,000, he would not have a taxable gain. Had Jack sold the property for $400,000 just before his death he would have had 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 also be a step down in basis.
Additional inheritance tax benefits
Another tax benefit is that a gain from the sale of inherited property is treated as being held long-term. Thus, then receives the benefit from the lower long-term capital gain tax rates – even though the property is not held by the beneficiary over one year.
Spousal Inheritances
Where spouses jointly own property a surviving spouse will sometimes only inherit half of the property. This is because they already owned half as a spouse. Thus that spouse only receives a basis adjustment on the inherited portion of a property. However, when spouses live in a community property state like Washington this is not the case. In this case, the surviving spouse receives a basis reset to the FMV of the entire property. This is because they receive the 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 jointly owned property? This is another benefit of inheritances as the accumulated depreciation goes away. And the beneficiary, if using the inherited property for business purposes or as a rental, simply restarts the depreciation from scratch on the inherited portion.
Gifting Prior to Death
Another issue is that some individuals choose to gift property prior to death. This is common with 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 basis. Therefore, there is no step-up in basis as previously discussed. So, unless there are other underlying issues, it is not a good idea tax-wise to make large gifts of property.
Example of a gifted property: Mom is in her 80s. 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, and 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.
Inheritance and tax laws are complicated. It is generally good practice to pre-plan for inheritances and gifting. Call for a tax planning appointment if you would like assistance.
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