President Biden in April of 2021 proposed the removal of a key tax advantage for real estate called the step-up in basis for inherited property. Anyone who’s dealt with inherited property likely knows how important the step-up in basis can be for real estate that’s transferred to heirs upon the owner’s death.
If you’ve filed out tax forms for the sale of inherited property, the step-up in basis is a key component. Although for tax filing purposes, it is called the fair market value. In this article, we’ll look at which tax forms are involved with the sale of inherited property and provide a few examples of what a step-up in basis looks like.
Schedule D and Form 8949
Schedule D is where any capital gain or loss on the sale is reported. A gain or loss is based on the step-up in basis, if applicable. Disposition of the property is reported on Form 8949. This form contains details such as the date it was acquired, the date it was sold, and a description of the asset. The gain or loss on the property is also listed on Form 8949 and gets carried over to Schedule D.
The step-up in basis is derived at the time of inheritance using Form 8971 and Schedule A and is usually filed by the executor of the estate.
Example of Step-up in Basis
The step-up in basis is the market value of the property at the time of inheritance, which coincides with the death of the property owner. In other words, the property is inherited upon the death of the owner.
Here’s an example: a home was purchased 20 years ago for $250,000. Today, the residence is worth $1 million. When the homeowner dies, the heirs inherit the home for $1 million, which is its current fair market value. For the heirs, the cost basis has stepped up from $250,000 to $1 million.
If the heirs sell the property at its fair market value ($1 million), they would not owe any capital gains taxes, although transfer taxes still would be due at the time of sale. If they sold the home for $1.1 million, the heirs would pay taxes on the $100,000 capital gain.
This type of inheritance is called lineal, which specifies the heir(s) relationship to the owner. Lineal descendants include the spouse, parents, grandparents, great-grandparents, children, stepchildren, grandchildren, and great-grandchildren. Non-lineal descendants, meanwhile, include nieces and nephews. Non-lineal descendants will owe inheritance taxes in states that levy an inheritance tax.
Inheriting versus Gifting
Inheriting a property and gifting a property are not the same. If the parents gift a house to their son, he assumes the property at the original cost basis. Let’s use the same scenario as described above. The son assumes the $250,000 cost basis rather than the $1 million fair market value. If he sells the house for $1 million, he owes capital gains taxes on $750,000 net profit.
In this scenario, some parents will put the house into an irrevocable trust to take advantage of the step-up in basis provision. However, the trust language and certain other restrictions must be carefully applied. Investors interested in taking this route should speak with an experienced trust attorney to formulate an estate plan.
Another strategy that can help save on taxes of gifted properties is the 1031 exchange. Instead of selling the property outright, the heir can execute a 1031 exchange, which will allow him to defer taxes on the gain provided he rolls the entire sale proceeds over into a replacement asset.
Importance of Estate Planning and the Step-up in Basis
Leaving highly appreciated real property assets to your heirs can help preserve your financial legacy. If you sell those assets prior to your death, you’ll have to pay capital gains on any proceeds above your original cost basis. However, by leaving them to heirs of your choosing as part of your estate plan, those heirs can take possession of the assets at the current fair market value.
Despite the uncertainty created by President Biden regarding the step up in basis and estate taxes, this tax-advantaged estate planning strategy still can be a more efficient way to pass on highly appreciated assets than divestiture while you are still alive.
Inheritance Tax and States
Despite some investors' best efforts to save on taxes, several states charge an inheritance tax on the asset's value. These states include Kentucky, Iowa, Nebraska, New Jersey, and Pennsylvania.
Reporting the sale of inherited property isn’t complex. It only requires two forms (Schedule D and Form 8949) in most cases. Of course, investors will want to work with their accountant to ensure everything is done correctly for their specific situation.