Stepped-up Basis is what makes all of the deferred taxes on the Capital Gains and the Depreciation Recapture go away.
This happens when you pass your property to your heirs.
Stepped-up Basis turns “tax-deferred” into “tax-free.”
But before we look at Stepped-up Basis, let’s just look at what “Basis” is, and go from there.
BASIS IN REAL PROPERTY
If you own real estate, you have a “Basis” in that property. This is true of all assets, including stocks, but we are dealing primarily with real estate and some personal property.
There are 3 ways that your Basis in the property comes into existence.
Either you bought the property, you received the property as a gift, or you inherited the property.
STEPPED-UP BASIS IN PURCHASED PROPERTY
There is no Stepped-up Basis in purchased property, you make your own Basis.
Internal Revenue Code (IRC) Section 1012, entitled “Basis Of Property – Cost,” says very simply that “The basis of property shall be the cost of such property…”
It goes on to cover specific and unusual situations, but “Cost Basis” is the general rule for purchased property.
If you purchased a Duplex for $265,000 today, your Basis in that property is what you paid for it, plus any costs of acquisition.
If your cost of acquisition was $5,000, then your Basis in the property is $270,000.
If you spend $30,000 improving the property, then your Basis in the property becomes $300,000.
If you rent out the property, which you will, you will claim an annual depreciation allowance, and deduct that amount from your rental income.
But first you must determine something called your Depreciable Basis, because all of the $300,000 property is not depreciable.
The land on which the building is sitting is not depreciable, so you must separate out the value of this portion. Let’s assign $25,000 to the value of the lot.
That leaves a Depreciable Basis in the property of $275,000 which can be depreciated over a period of 27.5 years, resulting in an annual depreciation allowance of $10,000.
Yes, I manipulated the numbers. Did you see it coming?
After you have rented the Duplex for five years and claimed $50,000 in depreciation allowance, your Basis in the property is $250,000.
So, for property that you purchased, your Basis in the property will be the purchase price, plus cost of acquisition, plus cost of improvements, and minus depreciation allowed.
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STEPPED-UP BASIS IN GIFTED PROPERTY
There is no Stepped-up Basis in gifted property.
If you receive property as a gift, your Basis in the property will be the same as the Basis of the individual who gifted the property to you.
This is called the Carryover Basis.
IRC Section 1015, entitled “Basis Of Property Acquired By Gifts And Transfers In Trust,” says
If the property was acquired by gift … the basis shall be the same as it would be in the hands of the donor or the last preceding owner by whom it was not acquired by gift, except that if such basis … is greater than the fair market value of the property at the time of the gift, then for the purpose of determining loss the basis shall be such fair market value.
STEPPED-UP BASIS IN INHERITED PROPERTY
This is where the Stepped-up Basis comes in.
IRC Section 1014, entitled “Basis Of Property Acquired From A Decedent,” provides that the Basis of a Decedent’s property will be changed (usually inreased) to its Fair Market Value (FMV) as of the Date of Death (DOD).
IRC Section 1014(a) says
…the basis of property in the hands of a person acquiring the property from a decedent or to whom the property passed from a decedent shall, if not sold, exchanged, or otherwise disposed of before the decedent’s death by such person, be (1) the fair market value of the property at the date of decedent’s death, …”
It can be confusing, but it just means that there is a step-up in Basis when a person dies and leaves property to an heir.
However, it matters whether you are holding title to the property in your own name, or you own the property through a business entity.
You might still be entitled to claim a Stepped-up Basis, but it will depend on the business entity in which you are holding the property.
STEPPED-UP BASIS FOR BUSINESS ENTITIES
If you are not holding real property in your own name, then Partnerships and LLCs are the best business entities to use.
The LLC can elect for tax purposes to be treated as a disregarded entity, a partnership, or an S Corp. But it cannot be treated as a C Corp.
By taking an IRC Section 754 election upon the death of a shareholder, the Partnership or LLC gets a step-up in Basis for the property in the hands of the beneficiary.
For Example, let’s assume that you and your brother set up a corporation and each of you put in $50,000 and each of you own 50% of the stock. The corporation buys a warehouse for $100,000.
Ten years later, you die and leave everything to your son, and the warehouse is worth $1,000,000.
Your son will receive a Stepped-up Basis in the value of the corporate stock.
But the corporation will not receive a Stepped-up Basis in the value of the warehouse. If it is sold, the corporation will owe taxes on $900,000 of Capital Gains. In effect, your son will pay half of the taxes because it will come out of his share of the corporation’s funds.
Now, let’s assume that you and your brother set up an LLC instead of a corporation, and that everything else is the same. The LLC will be treated for tax purposes as a partnership.
When you die, your LLC makes a Section 754 election, and the son’s share of the LLC assets receives a Stepped-up Basis to $500,000.
If the LLC sells the warehouse, the son will have no Capital Gains taxes to pay. If the LLC does not sell the warehouse, the son has Basis of $500,000 inside the LLC which he can depreciate.
But be aware of the difference between “inside” Basis and “outside” Basis.
INSIDE AND OUTSIDE STEPPED-UP BASIS
There is a specific concern with Stepped-up Basis regarding business entities such as LLCs and Partnerships.
The Stepped-up Basis that we have been talking about applies to what is referred to as the “outside” Basis. This is the tax Basis in the hands of the successor owners.
But the step-up in Basis for the outside Basis will create a discrepancy with the “inside” Basis. The inside Basis is the successor owner’s share of the entity’s Basis of its assets as recorded on the books.
In order for successor owners to realize the tax benefits of the step-up in outside Basis, there must be a corresponding step-up in the entity’s inside Basis. This allows successor owners to claim current tax deductions for additional depreciation and amortization on the step-up in Basis of the inside assets.
IRC Section 743(b) permits an adjustment to the inside Basis of the entity assets upon a transfer of ownership of an asset caused by the death of an owner or partner.
However, to claim this adjustment, the entity must have an IRC Section 754 election in effect. And this election can only be made by the Partnership Managers in the case of a Partnership, because it affects all of the owners of the assets, not just the deceased party.
STEPPED-UP BASIS FOR HUSBANDS AND WIVES
If a Husband and Wife own the real estate together, the survivor will receive a Stepped-up Basis in the share owned by the deceased spouse, but may or may not receive a Stepped-up Basis in their own share upon the death of the spouse.
It will depend on the state in which they live, and the manner in which they are holding title to the property.
If the real estate is held in Joint Tenancy, and one spouse dies, the surviving spouse will received a Stepped-up Basis in the share of the property inherited from the deceased spouse, but will not receive a Stepped-up Basis in the share of the property that was already owned. This share retains its Cost Basis.
But in Community Property states, the opposite is true. If the surviving spouse inherits the property, all of the property receives a Stepped-up Basis.
In our Example of a $300,000 property, if the Community Property surviving spouse sold it shortly after the death of her spouse for $500,000, there would be no Capital Gains tax because the Sales Price would be the same as the Stepped-up Basis.
But if the Joint Tenancy surviving spouse did the same, her Basis in the property would be $150,000, half the Cost Basis of $300,000, plus $250,000, the Stepped-up Basis of the share of the deceased spouse, for a total Basis of $400,000.
The Joint Tenancy surviving spouse would have a $100,000 Capital Gains tax liability.
These Examples ignore allowable Depreciation.
Community Property states are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin.
Alaska allows spouses to opt-in to a Community Property arrangement.
STEPPED-UP BASIS AND FEDERAL INHERITANCE TAX
Post-mortem tax compliance and reporting are a very specialized and fairly complex area of the tax world.
But the Overview is quite simple.
The goal is to keep the newly declared Basis in the assets as high as possible so that when they are sold, there will be the smallest amount of Capital Gains to report.
On the other hand, in doing the Form 706, Estate Tax Return, the goal is to value the assets as low as possible in order to minimize, or escape altogether, the estate tax.
The Estate Tax Exemption in 2016 was $5.45M.
States have their own tax systems, and only six of the states have an Inheritance Tax. They are Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania.
In the past there have been abuses, and the IRS has a new reporting requirement.
The estate must now notify beneficiaries of the asset values reported on the estate tax return.
IRC Section 1014(f) is a new paragraph of the Section that requires beneficiaries to use a Date of Death (DOD) valuation for cost basis purposes that is no larger than the amount reported on the estate tax return.
And new IRC Section 6035 requires executors to file a new Form 8971 to notify the IRS who the beneficiaries are, along with a Schedule A that informs both the IRS and the beneficiaries what their inherited cost basis will be.
So, the former abuses have hopefully been curtailed.
Stepped-up Basis turns “tax-deferred” into “tax-free.”
But Stepped-up Basis is only available for inherited property.
The best situation is where the property is held in the name of one individual who dies and leaves the property outright to another individual.
If the property is held in the name of the Husband and Wife when one of them dies, the entire value of the property will receive a Stepped-up Basis if they live in a Community Property state.
But if the Husband and Wife do not live in a Community Property state, only the interest in the property owned by the deceased spouse will receive a Stepped-up Basis.
If the property is owned by an LLC or Partnership, and one of the owners or partners dies, the entity can make a Section 754 election to have the asset property receive a Stepped-up Basis.
If the property is owned by a corporation, the property will not receive a Stepped-up Basis when the shareholder dies.
After years of abuse involving conflicting values assigned to property by the estate administrator for estate tax purposes, and by the beneficiaries for Stepped-up Basis, the IRS now has specific rules to prevent that.
Stepped-up Basis is one of the three best concepts in the Tax Code for the real estate investor.
The other two are Section 121 and Section 1031.
Using all three is the ultimate lifetime investing plan.