The Home Office Trap

The Home Office Trap

The Home Office Trap The previous section pointed out that any depreciation taken on investment property would not be shielded by the primary residence exemption.
The examples used so far have all been about rental or investment property converted to a primary residence.

Depreciation, however, is taken not just on rental property but also on other types of property used for business. One item commonly depreciated is the home office.

If you qualify, you have the right to allocate a portion of your home as a home office and to take expenses associated with that home office, including depreciation. The question is whether it is worth it.

Example:
Victor and Carol live in a small, but expensive, two-bedroom home. Victor is a real estate broker and does most of his business from home. Victor claims one bedroom of his home as a home office for tax purposes, using it exclusively for business. He has allocated 30 percent of his home as a home office and has taken a depreciation expense of approximately $5,500 on it for the last six years.

Unfortunately, many people don’t understand that the amount of depreciation taken on their home office will have to be recaptured and taxed when the home is sold. In the example above, if Victor and Carol sell their home this year, they will have to pay $8,250 in federal taxes and an additional amount to the state.

It is possible to do a 1031 exchange on that portion of the house used as an office into a corresponding percentage on the new house, but it becomes very complicated and tends to cause problems with mortgage providers.

Whether the immediate year-to-year tax advantages of a home office deduction are worthwhile depends on your own particular tax situation, but keep in mind the primary residence $250,000–$500,000 exclusion will not protect you from taxes due on the recapture of any depreciation taken after May 6, 1997.

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What is Recapture of Depreciation

What is Recapture of Depreciation

The What is Recapture of Depreciation As we saw in the previous example, it is possible to convert investment property to a primary residence. That example was, however,
uncharacteristically perfect because the facts left no doubt that the taxpayers could increase the fair market value while at the same time decreasing the tax liability. The facts also stated that the property had been fully depreciated since 1995.

In the real world, there is seldom such a large upside potential, and the property is usually still being depreciated. This complicates the issue because even though the primary residence exemption may apply, it will not shield that portion of the gain equal to the depreciation taken on the property after May 6, 1997 (the effective date of the Taxpayer Relief Act).

Example:
In 1996 Joe bought a rental condominium in California for $200,000, which he is considering selling in 2003 and looking at the tax issue. The current market value of the property is $300,000, and the current adjusted basis is approximately $155,000. Joe knows the capital gains tax on the sale is going to be approximately $44,200 if he sells it outright. The idea of writing a check to the IRS for that amount does not sit well with Joe, so he is trying to decide if it would be worthwhile to move into the property for two years to obtain the primary residence exemption. After doing the math, Joe realizes that he has taken approximately $45,000 in depreciation since May 6, 1997; and he knows none of that depreciation will be shielded by the primary residence exclusion. That means that even if he does move into the property for two years to qualify for the exclusion, he will still have to write a tax check for approximately $15,300.

If Joe is like most people, he is going to forgo trying to convert the property to a primary residence and instead will look for other alternatives. For most people, moving to a property for two years just to save on taxes is simply too disruptive of their lifestyle to actually do more than merely consider the option. However, it is nice to know that if the tax savings are high enough or the right situation presents itself, the option is available.

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Investment Property Converted to a Primary Residence

Investment Property Converted to a Primary Residence

The Investment Property Converted to a Primary Residence One question that always comes up is whether a taxpayer can “convert” or “recharacterize” an investment property to a primary residence and thereby qualify for the primary residence exemption.

The answer is clearly yes. But the owner and the property will have to meet all of the primary residence exclusion tests; this means the taxpayer will actually
have to use the property as his or her primary residence for the two-year use period. Sometimes that is simply too high a price to pay to qualify the property for the exemption, but sometimes it is a smart move.

Example:
Jack and Barbara, who are both retired, live in a suburb of San Francisco but are planning a move to Palm Springs. They own a triplex within the San Francisco city limits that was left to them many years ago by Barbara’s mother and has been fully depreciated since 1995. The triplex was originally built as a single-family house but had been converted over the years to three one-bedroom apartments. The property is very valuable already, but lately there has been a tremendous demand for restored San Francisco–style homes, and the neighborhood has become very upscale. Single-family homes in the immediate area have been selling for $700,000 to $800,000. Jack and Barbara both like to keep busy and think restoring their property would be a great project and a way to spend extra time in San Francisco before moving to Palm Springs. This is a perfect situation for converting an investment property to a primary residence. Jack and Barbara will have to move tenants out to start the restoration project. But if they are willing to move in while working on the restoration, they can convert the property so that the entire triplex is restored to a residence and will qualify for the married couple’s $500,000 gain exclusion.  In California, that will save them approximately b$140,000 in a combined state and federal capital gains tax. In addition, the process of living in and restoring the property will probably enhance the property’s fair market value. All in all, it seems like a smart move on Jack and Barbara’s part.


The downside to converting or recharacterizing investment property to primary residence or partial primary residence is that the depreciation taken on the property, as discussed further in the next section, will have to be recaptured on the sale.

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Fractional Exemption Use For Investment Property

Fractional Exemption Use For Investment Property

Fractional Exemption Use For Investment Property Although the primary residence exclusion is normally associated with single family homes, it does apply to other types of living arrangements. Resident-owners of apartment buildings can qualify on a percentage basis.

If the resident-owners meet both the ownership and use tests for the property and have not claimed the exclusion on another property in the past two years, they are able to shield a percentage of the gain on the sale of their apartment building by claiming the primary residence exemption for that portion of the property used as their primary residence. The remaining portion will, of course, be taxed as investment property on the sale.

Example:
Paul owns a four-unit property that consists of a large three-bedroom unit in the front and three smaller units in the rear. Paul lives in the front unit and meets all the other criteria for a main home exclusion. When Paul sells the property, he will be able to allocate a portion of the total gain to his primary residence and take the primary residence exclusion. The question: how much? That depends on how the property taxes for the property have been filed in the past.

Presuming Paul has taken all the available depreciation on the investment property portion of the property, he or his accountant has probably already allocated the portion of the property that represents primary residence and the part that is investment property. If the allocation has not already been made in prior tax returns, Paul will be able to use just about any reasonable allocation method.

On a four-unit property the taxpayer could simply allocate 25 percent (one of the four units) of the property as his main home and the remainder as investment property. On the other hand, if the owner’s unit is 1,800 square feet and the other three units combined equal 1,800 square feet, Paul could allocate 50 percent of the property as his primary residence.

The IRS allows any reasonable allocation; how Paul allocates is crucial in understanding future tax consequences. Herein lies a paradox: On one hand investors usually want to maximize depreciation while the property is operational, so they tend to allocate a higher percentage as investment property; on the other hand, when owner-residents sell the property, they want to claim a higher percentage as primary residence. Remember, the primary residence portion of the gain up to the $250,000–$500,000 limits is tax free. The remaining portion allocated as investment property gain is fully taxable.

Even had an unfavorable allocation been made on prior tax returns, it is possible to back up and refile past tax returns to change the allocation. In the alternative, you can also change the allocation for the current year and wait until the newly allocated portion meets the ownership and use tests as a primary residence. If you are going to change a past allocation, be sure to discuss it with your tax advisor first.

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Exceptions to the Two-Year Requirements

Exceptions to the Two-Year Requirements

The Exceptions to the Two-Year Requirements Because the general rule requiring a taxpayer to have owned and lived in a home for two of the last five years is firm but not set in stone, exceptions to the rule do exist. Likewise, there are exceptions to the rule that you not take the primary residence exemption more than once in any two-year period. The regulations provide an exception if you did not meet the ownership and use tests or your exclusion would have been disallowed because you sold more than one home in a twoyear period if you are selling your home as a result of the following:

1 A change in your place of employment
2 Your health
3 Unforeseen circumstances “to the extent provided in the regulations”

The first of these three exceptions a change in your place of employment is the most commonly used, and its meaning seems clear.

Example:
Ted and Tish bought their current home about one year ago. They sold their previous home one year ago and used their primary home exemption on that sale. Ted works for a large international corporation and has just been notified that he is being transferred to another state. Ted and Tish’s current home will not qualify for a primary
residence exemption because they have not met the two-year ownership or use test. In addition, even if they could otherwise meet the ownership and use tests, they would be disqualified from taking the exemption because they have used their exemption on the sale of another property less than two years ago. However, by applying the change-in-the-place-of-employment exception, Ted and Tish will be able to take a reduced exemption.

The employment change does not have to be an involuntary transfer or even one with the same company. In the above example, if Ted had simply decided to take a better job in a different area of the country, the exemption would still apply. If the change in place of employment involves a considerable distance, there is usually no question that the exception can be used.

The more difficult question arises when the change is close geographically. At the time of this writing, the IRS offers little guidance, so check with your tax advisor for any recent clarifications. The health exception is more ambiguous. The regulations don’t specify which health conditions qualify, so the exception may be a matter
of opinion, and the IRS’s opinion controls.

Obviously, if an illness is well documented in your medical records and your physician writes a supporting letter stating that the change is necessary, your chances of being disallowed on an audit are lessened. However, if you are trying to use this exception because you feel the change will do you good, you are likely to get resistance from the IRS. The best approach is to have good documentation supporting the move as the result of a verifiable medical condition.

The last exception—unforeseen circumstances—sounds like a fitall loophole. After all, just about anything that makes a person want to move twice in less than two years is arguably an unforeseen circumstance. In practice, however, this exception is useless because it applies only to unforeseen changes “to the extent provided in the regulations.” The problem is that currently there are no unforeseen circumstances Using the Primary Residence Exclusion 37

Example:
Ted and Tish bought their current home about one year ago. They sold their previous home one year ago and used their primary home exemption on that sale. Ted works for a large international corporation and has just been notified that he is being transferred to another state. Ted and Tish’s current home will not qualify for a primary
residence exemption because they have not met the two-year ownership or use test. In addition, even if they could otherwise meet the ownership and use tests, they would be disqualified from taking the exemption because they have used their exemption on the sale of another property less than two years ago. However, by applying the change-in-the-place-of-employment exception, Ted and Tish will be able to take a reduced exemption. provided in the regulations. Even IRS Publication 523, Selling Your Home, goes on to say after telling you that this exception exists:

The IRS has not issued regulations defining unforeseen circumstances. You cannot claim an exclusion based on unforeseen circumstances until the IRS issues final regulations or other appropriate guidance.

Much effort has been made by the accounting community to persuade the IRS to issue regulations explaining what is meant by unforeseen circumstances. Some suggestions of what should be allowed include sales resulting from divorce, job loss, health conditions of a nonowner family member, environmental problems, safety issues, and the death of a family member. But despite all the efforts, it is unlikely that the IRS will rush to issue regulations clarifying, or creating a use for, the unforeseen
circumstances exception anytime soon.

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How The Required Two-Year Period is Calculated

How The Required Two-Year Period is Calculated

How The Required Two-Year Period is Calculated One of the commonly misunderstood areas of the primary home exemption is how the periods are calculated to meet the ownership and use tests. For the average person who has owned and lived in his or her home for the past two or more consecutive years, there is usually no question of qualifying for the exemption.

However, calculating the period becomes a little more difficult in situations where the use has not been continuous, the exemption has been previously claimed, or where one of the spouses does not meet one of the tests. The general rule is that a taxpayer must have owned and lived in the home for two of the last five years. It does not matter which two of the last five years or that the two years are contiguous.

Example:
When Bob moved to Denver three years ago from Los Angeles, he decided to rent his Los Angeles home for a while instead of selling it. He had owned and lived in the Los Angeles home for many years, including the two immediately prior to moving to Denver. Bob recently completed the sale on the Los Angeles home and would qualify for the primary home exemption on the sale of that home.

Example:
Sally has had a beach house in New Jersey for 31/2 years. Two years ago she moved to New York City after having lived in the beach house as her main home for 18 months. She has continued to use the beach house on weekends and holidays while living in the city. Currently, she is planning to rent her city home and move back to
the beach house for 6 months and then relocate to the West Coast. After the 6 months back at the beach house, each of Sally’s homes will qualify for the exemption but not if both are sold within a 24-month period. Before Sally relocates, she intends to sell the beach house and use her primary home exemption to avoid taxes on the profit. She also plans to sell the city home 2 years later and use the primary home exemption again to avoid taxes on the profit from that sale. Sally will qualify for both exemptions because she will be able to show that she meets the criteria for both homes and did not try to use the exemption more that once in a 2-year period.

Example:
Before Don and Julie got married about a year ago, both owned their own home. When they got married, they decided to live in Julie’s home so Don sold his, using the primary residence exemption to shield him from taxes on the gain. Currently, Don and Julie have decided they need a bigger home and want to sell Julie’s house and relocate. The estimated gain on Julie’s house is $400,000; they plan to use the married couple primary residence exemption of $500,000 to shield them from taxes on the gain. Unfortunately, they do not qualify for the full married couple exemption because Don doesn’t meet either the ownership or the use tests. Julie does meet both tests and could file a separate tax return and claim her exemption, but that would only shield $250,000 of the $400,000 anticipated gain. Don and Julie’s two main alternatives are:

1. Wait one more year so they both qualify and use the married couple $500,000 exemption at that time.
2. Sell now using only Julie’s $250,000 exemption (filing separate tax returns) and pay the taxes on the other $150,000 of gain.

Don and Julie’s situation in the example above would not normally pose too much of a problem because it usually takes a few months to sell a home and locate a replacement. This means that Don and Julie can start the selling process in about nine months and time the closing of the property for a day or two after the two-year mark. In most cases, figuring whether a property (and taxpayer) qualify for the exemption is not difficult. If there are questions, be sure to discuss them with your tax advisor. Sometimes, however, a taxpayer simply does not meet the two-year tests but has no choice but to move now. In those situations, which will be discussed below, the regulations may allow a partial or fractional portion of the exemption to be taken.

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Property that Qualifies as a Primary Residence

Property that Qualifies as a Primary Residence

The Property that Qualifies as a Primary Residence There are two tests to determine whether a property qualifies for the $250,000/$500,000 primary residence exemption. To be entitled to the exclusion you must have:

1. Owned the home for at least two years of the last five years.
2. Lived in the home as your primary residence for at least two of the last five years.

These two requirements are referred to as the “ownership test” and the “use test.” There are certain exceptions to the two-year ownership and use requirements (discussed below), but as a general rule both these conditions must be met for a property to qualify for the primary residence exemption.

In addition, even if the property qualifies, you may be disqualified if you or your spouse has taken the exemption on another property within the last two years.

These two requirements are referred to as the “ownership test” and the “use test.” There are certain exceptions to the two-year ownership and use requirements (discussed below), but as a general rule both these conditions must be met for a property to qualify for the primary residence exemption. In addition, even if the property qualifies, you may be disqualified if you or your spouse has taken the exemption on another property within the last two years.

IRS publications refer to a primary residence as a “main home” A main home is not necessarily a traditional house; it can be a mobile or motor home, a boat that qualifies as a residence, a co-op apartment, or a condominium. Likewise, a fractional percentage of an investment property that is used as a primary residence may also qualify.

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What is the Primary Residence Exclusion?

What is the Primary Residence Exclusion?

What is the Primary Residence Exclusion? There is a significant difference between the tax liability on the sale of investment property and the tax liability on the sale of a primary residence. The main reason for this difference is a capital gain exclusion/ exemption created by the Taxpayer Relief Act of 1997.

Before the 1997 Act, the tax laws provided a primary residence rollover provision that allowed a homeseller 18 months in which to reinvest the gains in another primary residence without triggering taxes.

There was also a one-time, over-55-years-of-age-$125,000 exemption designed to let aging Americans buy down to a smaller home without being taxed on the first $125,000 of profit. Both of these provisions became history when the Taxpayer Relief Act took effect on May 6, 1997.

The new primary residence or “main home” exclusion is basically a $250,000 exemption for individuals and $500,000 exemption for married couples when selling a primary residence. So long as the property qualifies, there are no more rollover, or reinvestment, requirements and no minimum age requirements; further the new exemption can be used as many times as one likes but not more frequently than once in a two-year period. The actual rule in IRS Publication 523 is as follows:

You can exclude the entire gain on the sale of your main home up to:
1. $250,000, or

2. $500,000 if all of the following are true.
a. You are married and file a joint return for the year.
b. Either you or your spouse meets the ownership test.
c. Both you and your spouse meet the use test.
d. During the two-year period ending on the date of sale, neither you nor your spouse excluded gain from the sale of another home.

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Get it Done

Get it Done

The Get it Done is A step-up in basis does not happen automatically, so you have to file the appropriate paperwork with the IRS. As mentioned earlier, if you inherited a property or a portion of a property some time ago, you can still file for the stepped-up basis.

You need to establish the value of the property at the time you inherited it, so the longer you wait, the more difficult it may be to document a favorable valuation.

Remember, as a taxpayer you have the burden of proving the valuation; if you wait so long that no reliable information is available to support your appraisal, the IRS then is able to decide what your stepped-up basis will be. So no matter how long ago you actually received the property, getting an appraisal and filing now is probably to your advantage.

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Problems with Exaggerating the Value

Problems with Exaggerating the Value

The Problems with Exaggerating the Value Generally speaking, it is usually to your advantage to establish the highest possible value for stepped-up basis purposes, but there are times when a high date-of-death valuation is not to your advantage. Case in point: an optimistic or exaggerated value will hurt you if the property is
subject to estate taxes.

Example:
Carl’s father passed away a few months ago and left Carl and his sister an estate consisting of the father’s home and two small apartment buildings. The father had owned all three properties for many years; and Carl and his sister plan to keep all three for a few years before selling them. The approximate value of all three properties is $1,500,000. Carl knows he and his sister are entitled to a stepped-up basis on the properties, and he is trying to arrange for the appraisals now. Carl knows there can be variability in appraisals and wants to make the right decisions to minimize taxes. At the time of his father’s death, the federal estate exemption was $1 million.

Estate taxes at the time of this writing start at 37 percent and quickly go up to 50 percent. In the example above, Carl is going to face a certain amount of estate taxes on his father’s estate, but how much? If he hires an appraiser who leans toward a higher valuation, Carl and his sister will receive a higher stepped-up basis but will have to pay more in estate taxes now. In this situation, it is better to get as conservative a valuation as reasonably possible to minimize the estate taxes (37 percent or higher) at the expense of paying future capital gains taxes (20 percent) later.

A second situation in which an overly optimistic valuation may backfire is when, in a case with multiple heirs or partners, one heir or partner will be buying out the interests of the others. Obviously, in this situation a balancing of the respective interests is necessary.

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Obtaining the Highest Step-Up Possible

Obtaining the Highest Step-Up Possible

The Obtaining the Highest Step-Up Possible Even if the above IRS valuation requirements sound extensive and burdensome, they really are not. Almost all of the requirements are traditionally included in a standard professional property appraisal, and in most cases that is all you need to support your requested stepped-up basis value.

All appraisers, however, are not alike. Anyone in the real estate industry will tell you there can be a significant difference in appraised values on a given piece of real estate. Even in stable market conditions, it is not unusual to find appraisals differing as much as 20 to 25 percent, and that variable can make a huge difference in how much you’ll pay in taxes.

Example:
Betty and Hal had been married for 30 years when Hal died. Hal had left everything to Betty, including their California home and a sizable piece of vacant land. At the time of Hal’s death 10 years ago, the real estate market was booming, but the market had slowed down the year after he died, and prices had declined about 30 percent
on average. Betty really wasn’t aware of the downturn in the real estate market because she had no interest in selling. Recently, however, she has decided to move out of state to be near her daughter and grandchildren. Luckily, Betty’s timing is good because the real estate cycle has come full circle, and market values in her area have climbed back to the previous highs of 10 years ago. Betty’s home has a current market value of approximately $450,000, and she has recently been offered $400,000 for the vacant land. Both properties were bought almost 40 years ago—$30,000 for the home and $20,000 for the land. Betty has decided to sell both properties.

If Betty’s advisors fail to tell her about filing for the stepped-up basis on these properties, she will face taxes on the approximate $170,000 gain on her home ($450,000 sales price less the $250,000 primary home exemption less the $30,000 original cost basis) and another $380,000 gain on the sale of the land ($400,000 sales price less the $20,000 basis). Combined, Betty’s gain would be $550,000 and her tax liability approximately $159,000 (20 percent federal and 9 percent to California).

Assuming Betty has good advisors and files for the available step-up in basis, however, her tax situation will depend on how the properties were vested and how she inherited them. If both properties were held in either community property or in a revocable living trust as community or marital property, Betty will be able to file for a full stepped-up basis on each. Because the properties were inherited 10 years ago and the example states that the current values have “climbed back to the
highs of 10 years ago,” an appraisal of each property as of Hal’s date of death (also 10 years ago) should qualify Betty for a full basis step-up to today’s values.
Presuming valid appraisals did support a step-up to the current values, she could sell both properties and have no taxable gain at all. Even if the properties were both held in Hal and Betty’s name as “husband and wife as joint tenants,” Betty would still be entitled to a stepped-up basis but only on one-half (Hal’s half) of each property.

If held as joint tenants, her basis on the home would be approximately $240,000 (Hal’s half stepped-up to $225,000 plus Betty’s half at her original $15,000). After the step-up there would be no tax liability on the sale of the home because the $250,000 primary residence exemption would shield Betty’s $210,000 gain. On the land, however, there will be taxes. Betty’s new basis would be $210,000 (Hal’s half stepped-up to $200,000 plus Betty’s half at her original $10,000), and the gain on the sale would be $190,000 with a tax liability of approximately $53,100 (20 percent federal and 9 percent to California).

All of the calculations above presume one crucial factor: a supporting appraisal that shows the property values on Hal’s date of death are approximately equal to today’s market values. The example also presumes that a real estate market downturn had occurred between the date of death and the sale of the properties. Even had there been no downturn, a favorable appraisal to support a higher stepped-up basis would save a lot on taxes. Considering the 20 to 25 percent variation commonly seen between appraisers, which one you pick can either save you or cost you a lot. In the example above, both of Betty’s properties had a combined $950,000 estimated date-of-death value. If an overly conservative appraiser’s valuation came in at 25 percent lower, it might cost Betty tens of thousands in additional capital gains taxes.

Some appraisers are naturally more conservative than others. In addition, an appraiser’s level of conservativeness may vary dramatically depending on the purpose and use of the requested appraisal. Although not discussed often, a common practice is to look for the most favorable appraiser—in other words, to “shop” appraisers. Real estate agents do it, mortgage brokers do it, and attorneys do it, so it should be no surprise that the IRS also uses its “favored” appraisers in a dispute.

If you are going to file for a stepped-up basis either because it is time to sell or to gain a basis advantage on a property you intend to keep a while, you might try to tap into any professional real estate resources you have. Real estate agents, mortgage brokers, and real estate attorneys may have established relationships with appraisers, so if you can use their existing relationships, do so. If you were to simply start calling appraisers from directory listings, they might take offense if you “suggest” a particular outcome for the appraisal; that same suggestion between industry professionals, however, would not be unusual nor draw criticism.

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Using Fair Market Value to Your Advantage

Using Fair Market Value to Your Advantage

The Using Fair Market Value to Your Advantage As you can see, obtaining a stepped-up basis on a property can have a significant effect on your taxes when the property is eventually sold. Just as important as obtaining a stepped-up basis is making sure you get the most favorable stepped-up basis.

From the paragraphs above it should be clear that a stepped-up basis is always tied to, and based on, the fair market value of the asset at a specific time. But what exactly is the fair market value of an asset? Whether you inherited a property ten years ago or if you are inheriting one now, how you establish the fair market
value may determine your future tax liability. To understand the variables here, we need to start by defining fair market value, which, according to IRS Publication 523, is “the price that property would sell for on the open market.

It is the price that would be agreed on between a willing buyer and a willing seller, with neither being required to act, and both having reasonable knowledge of the relevant facts.” Thus, it is necessary to determine on what price a willing buyer and willing seller would agree. If you have just inherited a property and are selling it on the open market immediately, the actual sales price in an arms-length transaction will almost always be considered the fair market value. However, if you intend to keep an inherited property for some time before selling, or if you are going back now to file for a stepped-up basis on property you inherited some time ago, you then want to establish a favorable fair market value. The following is the IRS’s published appraisal guidelines for determining the value of real estate (IRS Publication 551):

Because each piece of real estate is unique and its valuation is complicated, a detailed appraisal by a professional appraiser is necessary. The appraiser must be thoroughly trained in the application of appraisal principles and theory. In some instances the opinions of equally qualified appraisers may carry unequal weight, such as when one appraiser has a better knowledge of 26 SELLING REAL ESTATE WITHOUT PAYING TAXES local conditions. The appraisal report must contain a complete description of the property, such as street address, legal description, and lot and block number, as well as physical features, condition, and dimensions. The use to which the property is put, zoning and permitted uses, and its potential use for other higher and better uses are also relevant. In general, there are three main approaches to the valuation of real estate. An appraisal may require the combined use of two or three methods rather than one method only.

1. Comparable Sales. The comparable sales method compares the property with several similar properties that have been sold. The selling prices, after adjustments for
differences in date of sale, size, condition, and location, would then indicate the estimated fair market of the property. If the comparable sales method is used to determine the value of unimproved real property (land without significant buildings, structures, or any other improvements that add to its value), the appraiser should consider the following factors when comparing the potential comparable property and the property:

a. Location, size, and zoning or use restrictions,
b. Accessibility and road frontage, and available utilities and water rights,
c. Riparian rights (right of access to and use of the water by owners of land on the bank of a river) and existing easements, rights-of-way, leases, etc.,
d. Soil characteristics, vegetative cover, and status of mineral rights, and
e. Other factors affecting value.

For each comparable sale, the appraisal must include the names of the buyer and seller, the deed book and page number, the date of sale and selling price, a property
description, the amount and terms of mortgages, property surveys, the assessed value, the tax rate, and the assessor’s appraised fair market value. The comparable
selling prices must be adjusted to account for differences between the sale property and the property. Because differences of opinion may arise between appraisers as to the degree of comparability and the amount of the adjustment considered necessary for comparison purposes, an appraiser should document each item of adjustment.
Only comparable sales having the least adjustments in terms of items and/or total dollar adjustments should be considered as comparable to the property.

2. Capitalization of Income. This method capitalizes the net income from the property at a rate that represents a fair return on the particular investment at the particular time, considering the risks involved. The key elements are the determination of the income to be capitalized and the rate of capitalization.

3. Replacement Cost New or Reproduction Cost Minus Observed Depreciation. This method, used alone, usually does not result in a determination of fair market value.
Instead, it generally tends to set the upper limit of value, particularly in periods of rising costs, because it is reasonable to assume that an informed buyer will not pay more for the real estate than it would cost to reproduce a similar property. Of course, this reasoning does not apply if a similar property cannot be created because of location, unusual construction, or some other reason. Generally, this method serves to support the value determined from other methods. When the replacement cost method is applied to improved realty, the land and improvements are valued separately. The replacement cost of a building is figured by considering the materials, the quality of workmanship, and the number of square feet or cubic feet in the building. This cost represents the total cost of labor and material, overhead, and profit. After the replacement cost has been figured, consideration must be given to the following factors:

a. Physical deterioration—the wear and tear on the building itself,

b. Functional obsolescence—usually in older buildings with, for example, inadequate lighting, plumbing, or heating, small rooms, or a poor floor plan, and

c. Economic obsolescence—outside forces causing the whole area to become less desirable. With this definition in mind, the IRS has told you exactly what it considers a valid appraisal. You may want to make sure your appraisal conforms.

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Filing For a Step-Up in Basis

Filing For a Step-Up in Basis

The Filing For a Step-Up in Basis A step-up in basis does not have to happen immediately. If you inherited property in the past as a joint owner, you may still file for a stepup.

You will have to establish the value of the property at the time you inherited it, but the effort and expense are usually well worthwhile. All property appraisers are able to give you an appraisal of the property at any particular time.

You may even be able to convince a local real estate agent to provide sufficient information to establish a fair market value on the date of death. However, if you have any reason to believe the valuation may be scrutinized, use an appraiser, not a real estate agent.

Once you have your supporting documentation for a date-of-death value, it is a simple matter of having your tax preparer file for the stepup in basis.

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Community Property

Community Property

The Community Property If you live in a community property state (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, or Wisconsin) and are married, you have the ability to hold property with your spouse as community property. Certain distinct tax advantages adhere in doing this. Unlike the other forms of joint ownership, community property vesting allows the surviving spouse to receive a full stepped-up basis on both the deceased spouse’s share and on the surviving spouse’s own share.

Example:
David and Mona, who had lived in California for most of their lives, were married for over 30 years. They owned two investment properties: (1) an apartment building with a basis of $100,000 and a fair market value of $500,000 and (2) a large parcel of vacant land with a basis of $10,000 and a fair market value of $610,000. Both
properties had been in the family for many years. David recently passed away, leaving everything to his wife. Mona will receive a full stepped-up basis on both properties to the current fair market value. She can sell both properties and pay no capital gains taxes.

This is a tremendous advantage over other forms of ownership vesting. In the example above, had David and Mona held the properties in joint tenancy, Mona would have received only a partial stepped-up basis and the capital gains taxes due would have been approximately $140,000 between federal and state taxes—a devastating result compared with the zero tax due when the properties were stepped-up as community property.

This type of vesting mistake is usually pointed out and corrected in any basic estate planning. Unfortunately, most people don’t even do basic estate planning. A simple rule here is that community property avoids taxes, joint tenancy avoids probate, but only proper estate planning (usually a living trust) avoids both.

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Joint Tenancy

Joint Tenancy

The concept of joint tenancy is a little hard for some to understand. Joint tenancy is commonly defined as a vesting in which each joint tenant owns an equal and undivided interest in the whole property. Joint tenancy is most commonly used in family situations, usually between husband and wife or parents and children.

The step-up in basis is very similar to the tenants-in-common example above, but there may be a need here to allocate and deduct some depreciation from the portion
getting the step-up in basis. The primary difference between joint tenancy and tenants in common is that when one joint tenant dies in a joint tenancy, his or her ownership interest automatically and instantly vests to the surviving joint tenant or tenants.

This means that individual joint tenants aren’t able to pass their ownership by “last will and testament” to heirs or whomever else they choose. Instead, their portion of the property goes directly to the surviving joint tenant or tenants.

Many times people use a joint-tenancy vesting as an estate-planning shortcut in an attempt to pass property to heirs and avoid the expenses associated with probating an estate. Unfortunately, this seemingly quick and easy probate avoidance tool usually results in undesirable tax consequences.

When joint tenancy heirs do eventually sell the property, they pay significantly more in taxes because they received only a partial stepped-up basis. Proper estate planning can avoid probate expenses and get the full stepped-up bases.

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What is a Stepped-up Basis?

What is a Stepped-up Basis?

What is a Stepped-up Basis? The term stepped-up basis refers to an adjustment or reallocation made to the basis of an inherited property. The concept of a steppedup
basis is fairly important because it directly impacts the amount of taxes you will face on the sale of inherited property and indirectly impacts the taxes your heirs will face if you pass an appreciated property to them as part of your estate. Let’s start with the official definition from IRS Publication 551, Basis of Assets:

Your basis in property you inherit from a decedent is generally one of the following:
1. The fair market value of the property at the date of the individual’s death.
2. The fair market value on the alternative valuation date, if the personal representative for the estate chooses to use alternative valuation.
3. The value under the special-use valuation method for real property used in farming or other closely held business, if chosen for estate tax purposes.
4. The decedent’s adjusted basis in land to the extent of the value that is excluded from the decedent’s taxable estate as a qualified conservation easement.

For most people who inherit property, either 1 or 2 above will apply. Basically, the rule is that if you inherit property, any gain made by the decedent is simply forgotten. You get the property with a new basis equal to its current fair market value and can sell it immediately without any taxes. If you think this sounds too good to be true, you may be right because there are estate taxes that have to be taken into consideration.

Before estate property passes to the heirs, it is going to be taxed at the estate level. Generally speaking, estate taxes are very high, topping out at around 50 percent. So it makes sense that an asset taxed at the estate level should not be taxed again if the heir sells it immediately. To avoid double taxation, the regulations allow a full stepped-up basis for the heirs.

Example:
Ralph owns an apartment building with a current market value of $500,000. His adjusted basis on the property is $100,000. If he sells the property outright today, he will have to pay capital gains taxes on a $400,000 gain. If, instead, Ralph had passed away and his son Carl, who inherited it, was selling it immediately, there would be no taxes because Carl would have received the property with a full stepped-up basis.

The potential problem is that if Ralph’s estate were in excess of the estate tax exemption amount for that year, this asset might have been taxed as much as $250,000 (50 percent) at the estate tax level before Carl ever got it. However, the vast majority of people inheriting property receive it from estates valued at less than the estate tax exemption. At the time of this writing, the estate tax exemption is $1 million per person and the exemption is scheduled to increase as follows:

Federal Estate Tax Exemption
Year Exempt Amount
2003 $1 million
2004 $1.5 million
2005 $1.5 million
2006 $2 million
2007 $2 million
2008 $2 million
2009 $3.5 million
2010 Unlimited
2011 $1 million (reverts)

Basically, the estate tax exemption means there are no federal estate taxes on estates valued at less than the exemption. So in the previous example, had Ralph passed away in 2003 leaving a total estate of less than $1 million, no estate taxes would be incurred, and his son would not face capital gains taxes because he received the apartment building with a full stepped-up basis. This is one of the few situations—loopholes— in which deferred tax liability actually disappears. The IRS is, however, moving to limit the amount of the stepped-up basis that can be taken, but for the time being the advantage is with the taxpayers.

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Estimating Your Tax Liability

Estimating Your Tax Liability

The Estimating Your Tax Liability It doesn’t take a CPA to estimate the potential tax liability on the sale of real estate. The math is fairly straightforward, but you have to know the three key factors previously described: the adjusted basis, the total depreciation taken, and the expected net sales price. From there you will be able to estimate what portion will represent capital gain and what portion will be taxed at the higher recapture-of-depreciation rate.

Example:
Tom has a rental property he has owned for 15 years. He originally paid $200,000 for the property, and it now has an expected sales price of $300,000. He has been depreciating the property for the full 15 years and his total depreciation taken to date is $100,000. His adjusted basis is now $100,000. If he sells the property, his taxable gain setting aside selling expenses, would be $200,000 (sales price less adjusted basis: $300,000 − $100,000 = $200,000). One-half of the total gain on Tom’s property is represented by recapture of depreciation and is therefore taxed at the 25 percent rate, and the remaining capital gain would be taxed at 20 percent, as shown in Figure 3.2. Thus, if the taxes were not deferred on the sale of this property, Tom would owe $45,000 in federal taxes. In the example above it is easy to see that the tax consequences of selling Tom’s property are significant. If this property were located in California or another state with similar state tax rates, the total state and federal taxes could be approximately $63,000 ($45,000 federal plus $18,000 state).

Estimating Your Tax Liability

A side note: If you buy into all the political posturing about eliminating federal capital gains taxes, remember that recapture of depreciation is still going to incur a 25 percent tax rate and state capital gains taxes will still apply.

So in the above California example, even with full elimination of a federal capital gains tax, there would still be approximately $43,000 in tax liability because of the tax on recapture of depreciation and the state-level capital gains tax.

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