Long-standing tax rules authorize an exceptional benefit for people who sell inherited assets that have increased in value — homes, stocks, real estate and works of art, to cite some common examples.
Inherited property gets what’s called a “step-up in basis” to its fair market value on the date of death of the previous owner. Thus, for tax purposes, the asset’s basis (generally, the cost of acquiring the property) becomes its value at the date of death, rather than the actual purchase price.
For heirs, that means forgiveness of capital-gains taxes on pre-inheritance appreciation and, on a subsequent sale, liability for taxes only on post-inheritance appreciation. When an asset has appreciated substantially over a lengthy holding period, the step-up in basis can translate into a considerable savings on taxes.
Inherited home: A step-up in basis. The following is an example: Walter and Susan Neff pay $100,000 for their house. The residence is worth $700,000 by the time both of them die, and their daughter Ceil inherits it. The home's basis steps up from $100,000 to $700,000. After their death, Ceil doesn’t use the property as her principal residence.
On a later sale, she can’t claim the profit exclusion of up to $500,000 or $250,000. Still, she sidesteps paying any taxes on $600,000 of appreciation while her parents lived in the home.
Because Ceil inherits the property, she owes taxes only on post-inheritance appreciation.
For a sale in 2017, her long-term capital gain gets taxed at a maximum rate of 20 percent (increasing to 23.8 percent if she owes the 3.8 percent Medicare surtax on investment income). Also, she must reckon with applicable state income taxes.
A gifted home: No step-up in basis. Suppose that Walter and Susan don’t stay put in their home and leave it to Ceil. Instead, they make a gift of it to her, a tactic that many potential gift givers have learned the hard way ought to be undertaken only after they attend a performance of King Lear or watch it on DVD.
Another consideration is that the rules for inherited property differ from those for gifted property. There’s no step-up in basis for lifetime gifts of property.
Instead, the basis carries over, meaning Walter’s and Susan’s basis at the time of the gift (usually, original cost, plus any improvements) becomes their daughter’s basis for figuring gain on a later sale. So when Ceil sells, she bases her taxable profit on the appreciation in value from the price her parents originally paid.
Let’s say Ceil unloads the property for a net sales price (after a reduction for all allowable sales expenses, such as a broker’s commission and legal fees) of $800,000. Her adjusted basis is $100,000 (the carryover of the $100,000 adjusted basis of her parents at the time of their gift; for simplicity, it’s assumed that Ceil doesn’t pay for any post-gift improvements that increase her basis). That leaves her with a gain of $700,000.
For a sale in 2017, Ceil owes taxes at a top rate of 20 percent (or 23.8 percent if she also owes the 3.8 percent Medicare surtax on investment income) on the entire long-term gain of $700,000, unless she uses the property as her principal residence for at least two years out of the five-year period that ends on the sale.
If that is the case, Ceil can exclude as much as $250,000 or $500,000 of the profit.
Additional articles. A reminder for accountants who would welcome advice on how to alert clients to tactics that trim taxes for this year and even give a head start for next year: Delve into the archive of my articles (more than 200 and counting).
Attorney and author Julian Block is frequently quoted in the New York Times, Wall Street Journal, and the Washington Post. He has been cited as “a leading tax professional” (New York Times), an “accomplished writer on taxes...