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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