At some point in our lives, we may inherit a home or another form of real property, which the Internal Revenue Service defines as “land and generally anything built on or attached to it.” To prepare for that possibility, it’s helpful to gain an understanding of some of the jargon that one can reasonably be expected to encounter when inheriting real estate. For instance, what does “cost basis” mean? And what is a “step-up,” and what kind of tax break does it offer?Very few people discuss such matters with their heirs before they pass away, and knowing what terms like these mean may make things less confusing at a highly stressful time. Further, consulting with legal and tax professionals greatly improves one’s chances of inheriting a loved one’s assets under favorable circumstances.
Cost basis is fairly easy to explain. It is the original purchase price of real estate, plus certain expenses and fees incurred by the buyer, many of which are detailed in closing documents. The purchase price is always the starting point for determining the cost basis; that is true whether the purchase is financed or paid in full. Title insurance costs, settlement fees, and property taxes owed by the seller that the buyer ends up paying can all become part of the cost basis.
At the buyer’s death, the cost basis of the property is “stepped up” to its current fair market value. This step-up in basis can reduce your and any other inheritors’ income tax liability stemming from the transfer of the real property.
Here is an illustration of stepped-up basis. Twenty years ago, Sylvia Davis bought a home for $210,000. At purchase, the cost basis of the property was $215,000. Sylvia died and her daughter Vicky inherited the home. Its present fair market value is $459,000. That is Vicky’s stepped-up basis. So, if Vicky sells the home and gets $470,000 for it, her complete taxable profit on the sale will be $11,000, not $255,000. If she sells the home for less than $459,000, she will take a loss; the loss will not be tax-deductible, as you cannot deduct a loss resulting from the sale of a personal residence.
The step-up can reflect more than just simple property appreciation over the years; many factors can adjust it over time, including negative ones. Basis can be adjusted upward by the cost of home improvements/additions, rebuilding costs following a disaster, legal fees linked to property ownership, and expenses of linking utility lines to a home. It can be adjusted downward by property and casualty insurance payouts, allowable depreciation as a result of renting out part of a home or using part of a residence as a place of business, and any other developments that amount to a return of cost for the property owner.
The Internal Revenue Code states that a step-up applies for real property “acquired by bequest, devise, inheritance, or by the decedent's estate from the decedent.” In plain English, that means the new owner of the property is eligible for the step-up whether the deceased property owner had a will or not.
In Wisconsin (as in other community property states), each spouse is automatically considered to have a 50% ownership interest in their real property. Upon the death of either spouse, the survivor will receive a step-up in basis to fair market value of the whole marital asset. This is what is known as a double step-up, because both spouses are allowed the step-up for their marital interest, and not just the deceased spouse’s interest.
The step-up in basis fair market value is commonly calculated as of the date of death. Alternately, the person inheriting the ownership interest may choose to utilize an “alternative valuation date.” This provision extends the valuation time frame to the earlier of six months after the decedents’ death, or the date the real property is sold.
In researching this post, I encountered a number of related scenarios that raised questions likely applicable to many of us, such as:
- What if a parent gifts real property to a child?
- If one inherits a home, can that person also qualify for the home sale tax exclusion?
- What is the “Special Use Valuation” for a farm or closely held business?
We encourage you to watch for future articles answering these questions. And, as always, if you or someone you know could use help or direction, please feel free to reach out to me via email, or at (608) 490-2231.