A: Thanks for your question, Raja! It’s a great one.
Ultimately, the answer to what happens to depreciation on an inherited rental property depends on the cost basis being used.
Depreciation with a step-up basis
In your case, since you were given a step-up cost basis, you won't have to worry about paying taxes on any accumulated depreciation. At its core, a step-up cost basis means that any increase in value to the asset that happened during your loved one’s lifetime isn't subject to capital gain taxes. It also does away with the need to recapture any depreciation your loved one took on the property while they were alive.
Put simply, you can start depreciating the property all over again, using your new step-up basis as a starting point.
You likely already know this, but in the interest of being thorough, you can determine your depreciation expense by dividing your cost basis for the property by 27.5. You’ll use a figure of 27.5 because the IRS says you can treat residential rental properties as having a useful life of 27.5 years. (Likewise, if you owned a commercial property, the depreciation period would be 39 years instead.)
Depreciation with the original cost basis
That said, there are a couple of exceptions to this answer. In particular, any situation where the original cost basis would be used instead of a step-up basis would still be subject to depreciation recapture.
For example, If the rental property was put in an irrevocable trust before your loved one's death, it would be treated as a gift for tax purposes. In that case, you would receive your loved one's original cost basis and, when you are ready to sell the property, you would have to plan for depreciation recapture.
On the other hand, if the person inheriting the property was a surviving spouse of the deceased and they had owned the property as joint tenants with right of survivorship, the original cost basis would be used in this scenario as well. Here, the surviving spouse would also have to account for depreciation recapture when they're ready to sell a rental property.
While calculating the recapture is a bit more complicated, you can use our guide on depreciation recapture to help walk you through the process. It's also worth noting that you can defer capital gains by doing a 1031 exchange.
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