The gain from the sale property is subject to income tax. Gain is generally the sales price minus tax basis, and tax basis is generally the cost or investment into the property. When a person owns property at death and the property passes to the heirs, the heirs get a tax basis equal to the fair market value on the date of the decedent’s death. This “stepped up” tax basis presents a number of planning opportunities.
Stepped Up Tax Basis Example
Consider the purchase of one share of Berkshire Hathaway in the early 1970’s. The investor would have paid about $100 for the share. That same share is valued at approximately $1 million today. Thus, if this one share was sold today, the investor would have a $999,900 gain ($1 million – $100). If the income tax rate applied to this gain is the current 15% capital gains tax rate, the sale would result in approximately $150,000 in federal income taxes (ignoring any state-imposed income tax).
The result would be different if the investor had held onto the share until the time he died and the share passed to his heirs pursuant to his will or, in the absence of a will, by way of state intestacy laws. The tax basis would step up to the fair market value of the share as of the day the investor died. If the heir immediately sold the stock, the heir would pay no income tax on the sale ($1 million – $1 million).
Stepping Up Basis in Depreciable Property
Stepped up tax basis can be particularly helpful for depreciable property, such as real estate. Depreciation refers to the deduction allowed to recover the cost of investing in certain capital assets, such a condo in Vail, Colorado that is held for the collection of rents. Let’s consider the same example above, but substitute the share of Berkshire Hathaway with a residential rental property.
The investor put in $1 million and has a $1 million tax basis (this assumes there is no land that the investor owns, as land is not depreciable). The taxpayer is entitled to a depreciation deduction equal to $1 million divided by 27.5, which is the class life the IRS assigned to residential real estate. The investor deducts this depreciation deduction each year, which offsets the rental income he received and possibly his other income (such as wages from his job).
These depreciation deductions reduce the investor’s tax basis in the property. If the investor sells the property, he would have a larger gain given the lower tax basis. This depreciation recapture is reported on the Form 4797 in computing the gain (or loss) on the sale (note: for simplicity, this article doesn’t go into the recapture of personal property that was part of the condo, such as stoves, refrigerators, etc. which may be taxed at different recapture rates).
But like the stock example above, if the investor had held the condo until his death and his heirs sold the property, they would step the tax basis up to the date of death value. They would not have to recapture the depreciation the investor had enjoyed.
Stepping Up Basis in Section 1031 Property
There are a number of other considerations. Section 1031 exchanges are an example. Section 1031 exchanges allow an investor to defer gain on the sale of one property (relinquished property) that is sold and replaced with a second property (acquired property) if certain timing rules are met.
Let’s consider Section 1031 exchanges and tax basis in the context of Private Letter Ruling 200706001. This ruling addresses whether a taxpayer is entitled to Section 1031 exchanged tax basis treatment for a transfer of one property that was received as a gift from a mother to the taxpayer for another property that is held in trust for the benefit of the mother (and with the taxpayer receiving a remainder interest in the trust).
Both of these properties were initially transferred to the taxpayer’s mother upon the taxpayer’s father’s death. Thus, the father opted to pass one parcel outright to his surviving spouse and he opted to place the other parcel in trust for the benefit of his spouse.
The IRS concluded that the transfers qualified for Section 1031 exchange treatment, even though they were between related parties. But what tax basis was used and what gain was deferred?
The property transferred outright qualified for a stepped-up tax basis and would leave a large depreciable basis in the new replacement property. The property that passed to trust did not.
There are a number of planning opportunities and pitfalls presented by the stepped-up basis rules. These issues can and should be addressed (1) by taking a fresh look at how property can best be titled (joint vs. individual, community property vs. separate property, entity vs. no entity, etc.) and (2) by monitoring (a) assets that are or are becoming low basis high appreciation assets (appreciating vs. depreciating assets, depreciable assets vs. non-depreciable assets) and (b) family changes that will present new real estate tax planning opportunities over time (marriages, deaths, etc.).