Stepped-up Basis: Inheritances Enjoy a Special Tax Benefit
- Learn the facts about stepped-up basis.
- What is inherited basis?
- Read a real-world example of inheritance basis.
- Learn about step-down basis.
- Find out how inherited property benefits from long-term capital gains tax rates.
- Learn about basis on jointly owned property.
- Find out how gifting prior to death affects basis.
You may hear people use the term “stepped-up basis,” but what does it mean? Many believe this is a tax provision that allows beneficiaries of an inheritance to reduce or even avoid taxes when and if they sell inherited property. Fiducial is here to tell you: This isn’t true.
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. This generally refers to the cost of the property reduced by business deductions, such as depreciation, attributable to the property.
However, for property received as a beneficiary, we use the term stepped-up basis. Tax law specifies that basis for most property received by a beneficiary as a result of inheritance is the fair market value (FMV) of the property as of the decedent’s date of death.
Stepped-up basis
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 equalled $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. 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 property with basis equal to FMV at the date of the decedent’s death. That means that it is not always a stepped-up basis; there could be a step-down in basis.
Another tax benefit of inheritance is that a gain from the sale of inherited property is treated as being held long-term. That means it gets the benefit from the lower long-term capital gain tax rates even though the beneficiary may not hold the property for 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. Thus, they only receive a basis adjustment on the inherited portion of a property. However, when the spouses live in a community property state, and the property is held as community property, the surviving spouse will get a basis 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, 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. We commonly see this when elderly parents gift 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 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, things can quickly become complicated when it comes to inheritances and gifts. It is generally good practice to pre-plan for inheritances and gifting. Need a tax planning appointment? Call Fiducial at 1-866-FIDUCIAL or make an appointment at one of our office locations to discuss your situation.
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