There are several tax concepts that are important for real estate investors, but for many people, step-up in basis is one of the least understood.
If you inherit assets, either real estate or otherwise, the step-up in basis rules can save you a tremendous amount of money on capital gains and depreciation recapture taxes, so it's certainly worth familiarizing yourself with how it works. With that in mind, here's a rundown of what step-up in basis is and how it applies to real estate investments in particular.
Step-up in basis has major implications for inherited property
When an asset is inherited upon the death of its original owner, it is often worth more than when it was originally purchased. In order to prevent a massive capital gains tax bill upon the sale of inherited property, the cost basis of the asset in question is changed to its value at the time of its owner’s death, a concept known as step-up in basis.
One important distinction is that this concept only applies to property transferred after death. If any property was gifted or transferred before the original owner dies, the original cost basis would transfer to the inheritor.
An example of step-up in basis
As a simplified example, let’s say that your uncle bought shares of a certain stock in the 1980s, and that he originally paid $25 per share. You inherit the stock in 2019, and it’s now trading for $200 per share. For capital gains tax purposes, the IRS would calculate any future gains as if you had paid $200 per share for the stock, not the $25 that was actually paid for it.
This is a massive tax benefit for estate planning, whether you decide to sell inherited assets right away or hold on to them for a while. Think of it this way -- in our example, if the stock had been sold the day before your uncle died, there would be a $175 taxable capital gain per share (assuming that it was owned in a standard, non-retirement account). If it was sold just the day after you inherited it, there would be no taxable gain whatsoever. If you hold the stock for a while, any capital gains tax would only be assessed on any difference between the eventual sale price and $200.
You might still owe estate taxes
It’s important to note that step-up in basis can allow heirs to avoid capital gains taxes. However, it does not allow heirs to avoid estate taxes that apply to large inheritances.
In 2019, the estate tax is levied on property in excess of $11.4 million per individual ($22.8 million per married couple). In other words, if you and your spouse leave a $25 million estate to your heirs, $2.2 million of this amount will still be taxable even though your heirs’ cost basis in assets they inherited will be stepped up for capital gains tax purposes.
There are certainly ways to avoid estate taxes if you plan well, but step-up in basis doesn’t exclude the value of inherited property from a taxable estate all by itself.
Real estate implications of step-up in basis
There are two big implications of stepped-up cost basis when it comes to inherited real estate assets.
First, just like with any other asset, you don't have to pay capital gains on any appreciation that occurred before you inherited the property. Selling an investment property after a long holding period can result in a big capital gains tax bill, so this can be an extremely valuable benefit.
The other side is that a step-up in basis can give you a bigger depreciation tax benefit. If you aren't familiar, the cost basis of residential real estate can be depreciated (deducted) over a period of 27.5 years. Obviously, a higher number divided by 27.5 years is a greater annual depreciation deduction than a smaller number would produce.
For example, let's say that you inherit a property that your parents purchased 20 years ago for $100,000. It is now worth about $250,000. Not only does a $250,000 cost basis translate to a $9,091 annual depreciation deduction, but you can take this deduction every year throughout the full 27.5-year depreciation period even though the previous owner likely claimed depreciation deductions for the 20 years they owned it. What's more, you won't have to pay a penny of capital gains tax on the $150,000 increase in value that occurred while your parents owned it.
Opportunity zone implications
There's one newer real estate situation where the concept of step-up in basis also applied. And it's worth noting that this is the only way step-up in basis applies to property you own while you still own it.
The Tax Cuts and Jobs Act created the concept of opportunity zone investing. You can read our thorough guide to opportunity zones, but the general idea is that these are geographical areas that are economically distressed, and that there is a new type of tax incentive designed to encourage investment activity in these areas.
Here's how it works. Let's say that you own some assets (stocks, real estate, etc.) that are worth far more than what you paid for them. You want to sell them to take some of your profits, but you've been hanging on to them because you know this would produce a massive capital gains tax bill.
However, if you were to sell those assets and re-invest the proceeds into a qualified Opportunity Fund (OF), your capital gains taxes on the sale are deferred until as long as December 31, 2026 or as long as you hold the investment in the fund, whichever comes first. There are also three other key dates to know:
- If the investment in the OF is held for at least five years, the basis for your reinvested capital gains is stepped-up by 10%, which will further reduce the eventual capital gains tax liability.
- If the investment in the OF is held for at least seven years, an additional 5% step-up in basis is awarded, and a total of 15% of the original gain that is excluded from taxation.
- If the OF investment is held for at least 10 years, any gains from that investment are permanently excluded from capital gains taxation, no matter how strong of a return is produced.
As you can imagine, opportunity zone investing can be a big tax break, especially if you're sitting on assets you'd like to cash out from.
Defer to the experts if you aren’t sure
As a final point, it's important to realize that estate transfers are a rather complex topic, and there's quite a bit of gray area and many potential question marks. For example, while it's easy to figure out how much a stock was worth on a certain date, how do you determine the value of real estate on the exact date of someone's death? Isn't that somewhat a matter of opinion? And how do you report the stepped-up basis of property you inherit to the IRS?
These are situations where seeking the advice of a qualified tax professional is very important. There's no way I can discuss every possible "what if" scenario here, so I strongly advise you to consult a professional to help you navigate your inherited property tax issues.