Question: We enjoy the regular supply of nuggets of useful information in your column. Regarding “stepped-up cost basis,” I have a question:
We own a condo in Arlington, Va., and a house in Monroe. The Monroe house is our primary residence, and we rent out the condo.
We bought it in 1993 and lived in it for only 28 months, 2005 to 2006, and so are not eligible for any relief on what would be a considerable capital gains tax. (The physical and cultural relief we gain from not living in the D.C. area cannot be calculated!)
When we die and our sons inherit, will the stepped-up cost basis apply to both properties?
Answer: The short answer is yes. Your sons will inherit your properties at the stepped-up cost basis, which means their “cost basis” in the properties would be the current market value at the time they inherit the properties.
Now, keep in mind that tax laws can change at any time. The Obama administration and Congress are currently fighting over tax laws scheduled to expire at the end of this year.
Under current tax law, you can leave an estate of up to $5 million without triggering the estate tax. But that provision expires at the end of this year. We don’t know yet what the new rules will be. But assuming your homes in Monroe and Arlington and the rest of your estate are worth less than $5 million, that’s not an issue.
So if there is no estate tax owed, the only time your sons would have to pay tax on the properties was if they sold them at a profit after they took title through inheritance.
Capital gains tax is based on the difference between your cost basis in the property (i.e. price paid) and your net proceeds after selling expenses. For example, if you bought your Arlington condo for $100,000 in 1993 and sold it for $250,000 this year with $25,000 in selling expenses, you would have net proceeds of $125,000. You would have to pay capital gains tax on that profit.
But let’s assume your sons inherited your condo this year. Their cost basis in the property would be the current market value of $250,000 rather than the $100,000 you paid for the condo. So if they immediately sold the condo for $250,000 they would not have any profit and therefore no capital gains tax. Of course, if the condo appreciates in the future, they would owe capital gains tax on any profits above their $250,000 cost basis.
That’s why it’s important for them to get an appraisal at the time they inherit the property, and since appraisers have some leeway in how they value a property, they should let the appraiser know that they would like to see a “maximum” market value to set their cost basis as high as possible.
Of course, this column is for general information only. Always consult a tax accountant to get professional advice before making any estate planning or real estate actions.
Email Steve Tytler at firstname.lastname@example.org.