If you are familiar with the concept of capital gains, you may have heard of the term “step up in basis.” Generally speaking, capital gains is the difference between the purchase price and the sales price of a particular asset. The IRS imposes a tax on all capital gains, as it is essentially income. When it comes to inherited property, though, the rule on capital gains is different. A “step up in basis” can provide a valuable tax break.
How the “step up in basis” works
A step up in basis basically adjusts the value of your inheritance in order to save on taxes. For instance, you may inherit a house from your uncle, which cost $70,000 when he purchased it. Now the home is worth $200,000, so your basis will be stepped up from $70,000 to $200,000, in terms of calculating your capital gains. So, if you later sell the house for $250,000, your capital gains would only be the difference between $200,000 and $250,000. Without the step up in basis, your capital gains would be $180,000, as opposed to $50,000.
Mistakes that effect the step up in basis
The step up in basis is a straightforward rule, but you can jeopardize these savings if you are not careful. Two of the most common mistakes are jointly owning your home or other appreciating asset with your child, and holding the title of your appreciating assets in joint tenancy with your spouse.
Joint ownership with your child
If it is your desire that your child inherit your home after your death, the best way to make that happen is to transfer the home to a living trust, which will pass the home on to your child upon your death. On the other hand, joint ownership with your child will prevent his or her use of the “step up in basis” rule. Instead, your child will be taxed on the capital gains for at least 50%, but could be as much as the full appreciation of the property, at the time that asset is sold.
Joint-tenancy ownership with your spouse
A similar problem exists when you hold the title of your home in joint tenancy with your spouse. Your surviving spouse will receive a setup in basis of 50%. The remainder will be taxed at the original cost of the home, as opposed to the step up in basis that would be available, if the house had been held in community property. Converting the nature of the asset to community property and holding it in the living trust will provide the best of both worlds by avoiding probate and getting the step up in basis.
Preserving the step up in basis
The step up in basis rule may be one of the most valuable tax breaks provided by the IRS, especially when it comes to assets that have appreciated substantially. It would be a terrible waste to lose or diminish this valuable benefit, by making mistakes that can easily be avoided. The best thing you can do to preserve this benefit, is to discuss your options with your estate planning attorney.
If you have questions regarding step up in basis, or any other estate planning needs, please contact Anderson, Dorn & Rader, Ltd., either online or by calling us at (775) 823-9455.