Written by Benny L. Kass
Question. I have seen a lot of material about the up-to-$500,000 exemption on tax of appreciated value on the sale of one’s home or up to $250,000 if you file a separate tax return . What I do not understand is what are the implications of all of this appreciation on my estate if I do not sell my house before I die. Must my heirs pay tax on the entire appreciation? How is this covered in the Tax Code?
Answer. This is a very complicated issue, and you must seek specific advice on your situation from your tax advisors.
Oversimplified, the basis of inherited property for income tax purposes is the fair market value of the property at the time of the decedent’s death. This is commonly referred to as the “stepped-up” basis rule. In other words, if the tax basis of the deceased was $80,000, on his death it increases — i.e. is “stepped up” to the value on the date of his death.
By way of illustration, if you purchased your property 20 years ago for $50,000.00, and over the years have made $30,000 of major improvements, your basis for tax purposes is $80,000.00. If you sell the property for $200,000.00, without taking into consideration costs or expenses of sale, your profit is $120,000.00. If you are eligible to claim the above-referenced exclusion of gain because you owned and used the house as your principal residence for two out of the five years before sale, you will not have to pay a tax on the profit you have made.
If, however, you do not – or cannot – take advantage of the exclusion of gain, you will have to pay capital gains tax on the $120,000.00 which you have made in profit. At current rates, depending on your income, it could be as high as 20 percent or $24,000 in Federal tax, plus any applicable state and local tax.
If, on the other hand, you do not sell your property, on your death your heirs will in most cases receive the benefit of this “stepped-up” basis rule. If the value of your property on the date of your death was $200,000.00, and your heirs sell the property for $200,000.00, then they probably will not have to pay any Federal income tax on this sale. They receive tax-free benefits of the appreciation during your lifetime. Obviously, if the heirs sell the property for $300,000.00, then they would have to pay tax on that gain, which in our example would be $100,000.00. Keep in mind that we are only discussing income tax and not inheritance tax.
According to the Tax Code, the stepped-up basis applies to property “acquired by bequest, devise, or inheritance, or by the decedent’s estate from the decedent. . .” This means that whether the decedent has a will, or dies intestate (without a will), the beneficiary is eligible for that stepped-up basis.
The law further goes on to address community property states, where each spouse has an undivided half interest in community property. In those states, an heir, devisee or legatee obtains the decedent’s half interest from the deceased spouse, and is entitled to a stepped-up basis under the general rules. The surviving spouse is also entitled to a stepped-up basis for his or her half interest if at least half of the community property in question is included in the decedent’s gross estate for tax purposes. (For more information, obtain the free IRS publication 555, “Community Property”, available Here.)
There is, however, an alternative valuation rule which can be adopted. This alternative valuation gives the taxpayer the election to value the property six months after the date of death or at the date of disposition, if earlier. The purpose of this election is to afford some limited tax relief to estates which have experienced a decline in the value of assets during that six months period. It is anticipated that with the decline in real estate many homes have encountered these past 5-7 years, many estates may give serious consideration to this alternative valuation method.
It should be noted that the stepped up basis will not apply to situations where you or your spouse gave the property to the decedent within one year before the decedent dies.
Obviously, the decision on whether to sell your property while you are living or pass it on to your heirs is a very important — and personal — decision. Some people want to make sure that their heirs will be properly protected on their death. Other people might very well want to make sure that they are protected while they are living. Too many people are, unfortunately, house rich and cash poor.
If, for example, you are sitting on a large amount of equity, and if you need cash now, letting your heirs inherit the property at the stepped-up basis will not solve your immediate cash problem. On the other hand, if you gift your house to your children, your tax basis becomes theirs. So unless they can take advantage of the up-to-$250,000 (or $500,000) gain exclusion, they may have to pay a hefty capital gains tax when they sell. They won’t really be happy campers at that time.
Thus, it is critical that you discuss all of these ramifications with your tax advisors at the earliest possible opportunity. And while you have the absolute right to decide how to deal with your own property, it would also be advisable to at least let your children know your decisions.
For general information on this subject, you should get the free IRS publication 551, entitled “Basis of Assets”.