Inheritances Enjoy a Special Tax Benefit
Updated: Apr 20, 2022
You may hear people use 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.
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, which generally means the cost of the property reduced by business deductions, such as 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, so they will have a stepped-up basis.
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, where 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, 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.
As you can see, our tax laws are complicated when it comes to inheritances and gifts. It is generally good practice to pre-plan for inheritances and gifting. Call for a tax planning appointment if you would like assistance.