When you sell a property, you are typically required to pay income tax on the gain, which is calculated as the difference between the sales price and the tax basis.
The tax basis is usually the amount that you paid to purchase or invest in the property plus the amount paid to improve the property. However, in situations where a property is inherited by heirs after the owner’s death, the heirs receive a “stepped-up” tax basis equal to the fair market value of the property on the date of the decedent’s death.
This “stepped-up” tax basis provides a range of tax planning opportunities that can help heirs minimize their tax liability when they eventually sell the inherited property. By understanding the implications of the stepped-up tax basis, heirs can make informed decisions about when and how to sell the property, as well as how to structure any potential transactions to reduce their tax burden.
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Stepped Up Tax Basis Example
Let’s take consider an example of how the stepped-up tax basis can work in practice. Imagine an investor who purchased one share of Berkshire Hathaway in the early 1970s for about $100. Today, that same share is valued at around $1 million. If the investor were to sell the share today, they would realize a gain of $999,900 ($1 million – $100), which would be subject to the current 15% capital gains tax rate, resulting in approximately $150,000 in federal income taxes (not accounting for any state-imposed income tax).
However, if the investor held onto the share until their death and passed it on to their heirs, the tax basis for the share would step up to the fair market value of the share on the day the investor died. In this scenario, if the heir were to immediately sell the stock, they would pay no income tax on the sale, as the sales price of $1 million would be equal to the stepped-up tax basis of $1 million.
This example highlights how the stepped-up tax basis can provide significant tax savings for heirs, particularly when dealing with appreciated assets like stocks. By waiting until the time of inheritance to sell the asset, heirs can effectively reset the tax basis to the current market value, avoiding the capital gains tax on any prior appreciation in the asset’s value.
Stepping Up Basis in Depreciable Property
The stepped-up tax basis can be particularly advantageous for depreciable property, such as real estate. Depreciation allows taxpayers to recover the cost of certain capital assets, like a rental property, over time.
For example, let’s consider an investor who purchased a condo in Vail, Colorado for $1 million, which they rent out for income. They have a $1 million tax basis in the property, assuming they do not own the land, which 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 can take this depreciation deduction each year, which reduces the rental income they received and possibly even their other income, such as wages from a job.
However, these depreciation deductions also reduce the investor’s tax basis in the property. If the investor decides to sell the property, they would have a larger gain due to the lower tax basis. This depreciation recapture is reported on Form 4797 when computing the gain (or loss) on the sale. It’s important to note that the recapture of personal property, such as stoves and refrigerators, which may be taxed at different rates, is not discussed in this article for simplicity.
Fortunately, as with the stock example above, if the investor had held onto the condo until their death and passed it on to their heirs, the heirs would be able to step up the tax basis to the fair market value of the property as of the date of the investor’s death. This means that they would not have to recapture the depreciation deductions that the investor had enjoyed, potentially saving them a considerable amount of money in taxes if they decided to sell the property.
Stepping Up Basis in Section 1031 Property
In addition to the examples above, there are several other factors to consider when it comes to stepped-up tax basis, such as in the case of Section 1031 exchanges. These exchanges allow investors to defer gain on the sale of one property (known as the “relinquished property”) if it is sold and replaced with another property (known as the “acquired property”) within certain timing rules.
For instance, Private Letter Ruling 200706001 offers an example of how Section 1031 exchanges and tax basis work together. This ruling addresses whether a taxpayer is entitled to Section 1031 exchange 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 (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. The father chose to pass one parcel outright to his surviving spouse, while he opted to place the other parcel in trust for her benefit.
The IRS ultimately concluded that the transfers qualified for Section 1031 exchange treatment, even though they were between related parties. However, the tax basis used and the gain deferred were dependent on the type of property transferred.
In this case, the property transferred outright qualified for a stepped-up tax basis, leaving a large depreciable basis in the new replacement property. The property that passed to trust did not qualify for the stepped-up tax basis, which could have significant implications for the gain deferred in a Section 1031 exchange scenario.
The Takeaway
The stepped-up tax basis rules can present a range of planning opportunities and pitfalls that should not be overlooked. To take advantage of these opportunities and avoid the pitfalls, it’s important to take a fresh look at how property is titled and monitor key factors over time.
When it comes to property titling, it’s important to consider various factors such as joint versus individual ownership, community property versus separate property, and entity versus no entity. Choosing the right structure can have significant tax implications, both in terms of minimizing the tax burden and maximizing the benefits of the stepped-up tax basis.
Additionally, it’s crucial to monitor assets that are or are becoming low basis high appreciation assets, including appreciating versus depreciating assets, depreciable assets versus non-depreciable assets, and changes in family dynamics, such as marriages and deaths. These changes can present new real estate tax planning opportunities over time, and staying on top of them can help ensure that you are taking advantage of all available benefits and avoiding potential pitfalls.
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