Inherited Property - What is My Cost for Tax Purposes?
You recently inherited assets of some kind (or expect to), and you know that at some point you likely will sell some of your new found wealth. Good for you!
With that blessing, however, comes a potential income tax. Have you thought about the tax consequences when you make that sale?
More specifically, most people understand that when you sell an asset, be it a financial asset or something more tangible like real estate, you have a potentially taxable sale, the gain or loss of which is measured by the difference in your sale proceeds and your "cost", more accurately termed "basis".
But what is your basis in property you inherit from someone else? This is an important question and is something all too often overlooked when families start to put their affairs in order.
In general, under the fair market value basis rules (also known as the "step-up and step-down" rules), the heir receives a basis in inherited property equal to its date-of-death value. So, for example, if Sam bought Acme Corp. stock in 1935 for $500 and at Sam's death, the stock is worth $5 million, the tax basis is stepped up to $5 million in the hands of his heirs, and all of that gain escapes income taxation forever.
Yes, you heard that right, forever! That is what you call a windfall, and is one of the few "gimmes" in the tax law.
The fair market value basis rules apply to inherited property that is includible in the deceased's gross estate, whether or not a federal estate tax return was filed, and those rules also apply to property inherited from foreign persons, who aren't subject to U.S. estate tax. The rules apply to the inherited portion of property owned by the inheriting taxpayer jointly with the deceased, but not the portion of jointly held property that the inheriting taxpayer owned before his or her inheritance.
It is crucial for you to understand the fair market value basis rules so that you don't pay more tax than you're legally required to pay.
For instance, if, in the above example, Sam, instead of holding on to the stock until death, decided to gift it in honor of his 100th birthday, the step-up in basis (from $500 to $5 million) would be lost. This is because assets that have gone up in value acquired by gift is subject to the "carryover" basis rules where the gift recipient takes the same basis the donor had in it (in Sam's case, just $500), plus a portion of any gift tax the donor pays on the gift.
A step-down, instead of a step-up, can also happen. A step-down occurs if someone dies owning property that has declined in value. In that case the basis is lowered to the date-of-death value.
Proper planning calls for seeking to avoid this loss of basis. In this case, however, giving the property away before death won't preserve the basis. This is because when property which has gone down in value is the subject of a gift, the recipient must take the date of gift value as his basis (for purposes of determining his loss on a later sale).
The best idea for property which has declined in value, therefore, is for the owner to sell it before death so he can enjoy the tax benefits of the loss.
These are the basics of the rules for determining basis in inherited property. In certain cases, there is an alternate valuation rule that can apply at the election of an executor that is beyond this article's scope.
Also, as with most tax rules that offer special benefits, smart people look for ways to exploit them beyond how they were intended. As a result, rules have been enacted to combat these moves. An idea that some taxpayers have tried to use is to pass property through a decedent to attempt to inflate basis under these rules.
For example, say Joe owns stock with a $1,000 basis and $20,000 value. Joe goes to his 97-year old uncle and arranges to "give" his appreciated stock to the uncle, who takes it with Joe's $1,000 basis. The uncle then dies leaving the stock back to Joe in his will. Under the basic rules, Joe regains ownership, but now with the basis stepped up to its $20,000 date-of-death value. However, under a rule to prevent this result, if the uncle dies within a year of when Joe made the gift, Joe still has his original $1,000 basis. The result is the same if, instead of leaving the stock to Joe, the uncle leaves the stock to Joe's spouse.
