Special Tax Benefit for Inheritances

You may have heard the term “Stepped-Up Basis”, that 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.

If an individual sells property, any gain from the sale of that property is taxable. The tax term “basis” is the value from which any taxable gain is measured. In regard to personal use or investment property, the basis is generally the cost of the property. For business property the term basis is replaced with adjusted basis, which usually means the cost of the property reduced by business deductions 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 an inheritance is the fair market value (FMV) of the property as of the decedent’s date of death. If the property appreciated over time, this 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: John has owned a rental property for several years that he purchased for $200,000. Over the years he claimed a depreciation deduction of $24,000 up to the time of his death. Thus, his basis when he passed away was $176,000. At the time of John’s death, the rental had an appraised FMV of $400,000. Bill, John’s only beneficiary, will have a basis of $400,000, and if he immediately sells the rental for $400,000, he would not have a taxable gain. However, had John 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 in basis.

Another tax benefit of an inheritance is that a gain from the sale of inherited property is treated as being held long-term and gets 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 since they already owned half, and thus only receive a basis adjustment on the inherited portion of a property. However, when a spouse dies in a community property state, the surviving spouse gets to ‘step-up’ the basis in both halves of the property and not just on the one-half of the spouse that died.

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 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 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: A mom in her 80s gifts her home, which she purchased for $100,000, to her only child Jack while she is still living. The home has a current value of $300,000. For gifts, the gift recipient’s basis becomes the giver’s basis, and in Mom’s case her basis was $100,000 which becomes Jack’s basis. As a result of the gift Jack has a $200,000 built in gain when and if he sells the home. If Jack had inherited his Mom’s home, his basis would have been $300,000 plus any additional appreciation before her death.

As you can see, tax laws can be complicated when it comes to inheritances and gifts. It is generally good practice to pre-plan for inheritances and gifting. To learn more about the special tax benefit for inheritances, contact us to schedule a tax planning appointment.