President Biden is proposing the removal of something 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 is. 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, along with 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. Form 8949 is where the disposition of the property is reported. It contains details such as the date acquired, date sold, and description of the asset. The gain or loss on the property is also listed on Form 8949 and 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 estate executor.
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.
As an example, a home was purchased for $250,000 20 years ago. Today it is worth $1 million. The homeowner passes away, and his heirs inherit the home. The heirs inherit the home for $1 million, its fair market value. For the heirs, the cost basis has stepped up from $250,000 to $1 million.
If the heirs were to sell the property at its fair market value (i.e., $1 million), they would not owe any capital gains taxes. Transfer taxes would still be due upon the sale. If they sold the home for $1.1 million, taxes would be owed on the $100,000 long-term 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 include nieces and nephews. Non-lineal descendants will owe inheritance taxes.
Inheriting vs. Gifting
Inheriting a property and gifting a property are not the same. If the parents gift a house to their son, he will assume the original cost basis. Let’s use the same scenario above. The son will assume the $250,000 cost basis and not the $1 million. If the house is sold for $1 million, the son will owe taxes on $750,000.
In this scenario, some parents will put the house into an irrevocable trust, taking advantage of the step up in basis. However, the trust language and certain other restrictions must be carefully applied. Investors who are interested in this route should speak with a trust attorney.
Another strategy that can help save on taxes of gifted properties is the 1031 exchange. Instead of selling the property outright, the heir can choose to execute a 1031 exchange, which will defer taxes on the gain.
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.