What is your basis for inherited property? Do you calculate basis differently for property you received as a gift? And what is “basis,” anyway? Let us try to explain.
First, what is “basis”?
The concept of basis is primarily a tax consideration. If you sell a piece of real estate for more than you paid for it, you may owe taxes on the gain in value — what accountants call your capital gain. But capital gain also includes allowances for contributions you made to the value during your ownership. Like the building you built on the property, for example.
For purposes of calculating your capital gain, the tax code allows you to adjust the purchase price to reach your basis. The figure might get reduced by some depreciation deductions, or increased by your improvements. The shifting calculation of increases and deductions is what we mean by “basis” for income tax purposes.
The same principles apply to all kinds of property, though it’s easiest to understand if you analogize to real estate. You can see the significance of calculating the original purchase price plus adjustments for stock, personal property — all sorts of assets.
To make the calculations easier, we’re going to deal with every lawyer’s law school nightmare: a piece of real estate known as Blackacre. When you bought it, you paid $100,000. Today it’s worth $250,000 (yay for you!). If you sell it at that price (and ignoring any costs of sale or other adjustments), you’ll owe the income taxes on $150,000 of capital gains.
What about the basis in inherited property?
While you’re puzzling over how to get the capital gains from Blackacre without having to pay any income taxes, you become very ill and you die before you can complete your plans. Your will leaves Blackacre to your daughter Deborah. What is Deborah’s basis for inherited property like Blackacre?
To resolve this question, we first have to talk about estate taxes. Arizona doesn’t levy them, but the federal government does. But your total estate doesn’t reach the $13.61 million level that would require your heirs to file an estate tax return, much less pay any tax. But that doesn’t actually affect the analysis.
Editorial aside: the 2025 number for estate tax liability will probably be $13.99 million. You heard it first here. But don’t get too excited; it will drop to just over half that figure on January 1, 2026 — unless Congress makes changes.
Back to your 2024 estate: because Blackacre was part of your taxable estate, it will get what practitioners call a “stepped up” basis. That means that Deborah will receive it at its 2024 fair market value — which we have already said is $250,000. If she sells it the next day for $250,000, she will owe no capital gains tax. If it goes up in value by, say, 10% before she gets it sold, her capital gain will be the $25,000 increase after your death.
Great! You should just give it to her right now, right?
Hold on. Things get somewhat more complicated. If you gave Deborah Blackacre today, she wouldn’t get a stepped-up basis. Why not? Because it would no longer be countable in your estate for estate tax purposes.
Again, it makes no difference that no one needs to file an estate tax on your (later) death. Deborah receives Blackacre with your basis for capital gains tax calculations. So if she sells it right away, she’ll owe the tax on $150,000 of capital gains — just as you would if you sold it before your death.
Besides, Blackacre is worth more than the $18,000 maximum annual gift, so that would cause a gift tax problem, right? Red herring alert: no, it would not. The $18,000 “maximum” annual gift (scheduled to increase to $19,000 in 2025, by the way) is just how much you can give away without having to file a gift tax return. Assuming you haven’t already made gifts of more than $13.61 million, you’d pay no gift tax by giving Blackacre to Deborah — though you’d have to file a gift tax return and your $13.61 million exemption would be reduced by today’s fair market value for Blackacre. So it’s better to give it to Deborah at your death than during your life.
But I want Deborah to have use of the property now!
Don’t despair. There are things that you can do to make things easier on both of you. Though there might be legal reasons not to choose one (or perhaps even any) of the following, you could consider:
- Retaining a life estate. You could give Deborah a “remainder” interest in the property, but retain the right to receive rents and manage the property during your life. This might require a gift tax return (though not for the full value of Blackacre), but allow Deborah to be assured that she will receive the property at your death; you couldn’t take back the property after giving her that interest. And then, because Blackacre would be included in your estate for estate tax purposes, she’d still get a full step-up in basis. This might not be an attractive alternative in every case, but it’s one tool to consider.
- Making Deborah a joint tenant with right of survivorship. This keeps the full value of Blackacre in your estate for estate tax purposes, but gives Deborah some current ownership of the property. That’s also the biggest drawback, by the way — you have given up your complete control of the property and now have a joint owner. But you were thinking of giving her the whole thing, so this might be a palatable choice.
Okay — can I give Deborah some reassurance about Blackacre?
Even though it might not be easy to give Deborah an interest in Blackacre now, you can help reassure her that she’s likely to receive it — and the stepped-up tax basis — on your death. You can make it part of your will, or you can consider any of these options:
- Signing a “beneficiary deed.” In Arizona (and in about half of all the states) you can make a gift that does not take effect until your death. The so-called beneficiary deed is revocable — so Deborah can’t completely rely on getting Blackacre at your death. But again, Deborah gets the basis on inherited property on your death, and this is more income-tax efficient than a present gift. We wrote about beneficiary designations, and beneficiary deeds particularly, just last month. The same tax basis rule applies to nearly all assets with beneficiary designations — with the notable exception of IRAs and qualified retirement accounts. They don’t get a stepped-up basis on the owner’s death, and the beneficiary will pay taxes on the money withdrawn as if it were their own IRA.
- Creating a living trust. You can avoid probate and reassure Deborah by signing a living trust that provides for her to receive Blackacre. You need to remember to transfer Blackacre into the trust’s name. But then when you die Deborah gets Blackacre with the basis for inherited property.
Figuring out the basis for inherited property is often confusing and counter intuitive. But the significance of avoiding the capital gains tax is usually pretty straightforward. We hope this helps you understand it better. But remember: our information here is just intended to help you understand the concepts, and you really, really need good legal advice about how to apply it in your individual facts. Talk to a lawyer.
