The step-up in basis in real estate is an important tax provision that applies to real estate and other assets transferred at death. It allows heirs to receive inherited property with a new basis that is equal to the fair market value of the property at the time of the decedent’s death. This means that when the heirs sell the property, they only pay capital gains taxes on any appreciation that occurs after the date of inheritance vs on the cost basis of the decedent who may have acquired it for much less.
This can have enormous tax advantages for real estate investors who also benefit from depreciation on rental property. For if they hold the property until death, and then pass on the depreciated property to their heirs when they pass away, not only can they benefit from a reduced income tax liability from depreciation if they never sell, but their heirs can avoid capital gains tax for the most part as they receive the property at the fair market value (vs the depreciated cost basis of the decedent) at the time of death.
Is stepped-up basis a loophole?
Whether the step-up in basis at death is a loophole in the US tax code is debatable, and answers will vary usually based on the respondent’s political leanings, and views on tax policy and wealth transfer. We’ll examine some of the arguments on both sides below.
Reasons why the step-up in basis is a loophole
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It allows the wealthy to pass on assets to their heirs without paying capital gains tax: Since the heirs receive a stepped-up basis in the assets at the time of the original owner’s death, they can sell the assets and avoid paying capital gains tax on the appreciation that occurred during the original owner’s lifetime. This can result in significant capital gains tax savings for the heirs.
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It contributes to wealth inequality: Critics argue that the step-up in basis contributes to wealth inequality by allowing the wealthy to transfer large amounts of wealth to their heirs without paying taxes on the appreciation that occurred during their lifetime. This can perpetuate wealth disparities and make it more difficult for others to accumulate wealth.
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It does not apply to other types of assets: The step-up in basis only applies to certain types of assets, such as stocks, bonds, and real estate. Other assets, such as art, jewelry, and collectibles, do not receive a stepped-up basis at the time of the original owner’s death. This can result in inconsistencies in the tax treatment of different types of assets.
4. Perhaps most importantly, rental property can be fully depreciated over time (i.e. 27.5 years for residential property), meaning a zero cost basis by the time the owner dies.
As a result, real estate investors could reap the benefits of fully depreciating their rental properties throughout their lifetime, and enjoying the reduction in their income tax liability, holding the property until death, and then passing the property onto their heirs without ever having had to pay capital gains tax (because they never sold), nor depreciation recapture (because they never sold).
Therefore a real estate investor is able to fully benefit from depreciation in reducing their income taxes throughout their lifetime, and if they hold the property until death, they can avoid capital gains tax on any actual appreciation of the property, plus avoid having to pay depreciation recapture (normally 25%).
Pro Tip: Land cannot be depreciated, thus technically only the structure can be fully depreciated. However, in practice, accountants may fully depreciate the value of a condo or co-op apartment because the land ownership component is deemed insignificant (i.e. in a condo building say with hundreds of units).
Inherited property tax basis
When an individual inherits property from a deceased person, the value of that property for tax purposes is typically “stepped-up” to its fair market value at the time of the original owner’s death. This means that the heir’s tax basis in the inherited property is equal to the property’s fair market value at the time of the original owner’s death, rather than the original cost basis of the property.
For example, let’s say that a person inherited a house from their deceased parent, and the fair market value of the house at the time of the parent’s death was $500,000. If the parent originally purchased the house for $200,000, the heir’s tax basis in the inherited property would be $500,000, not $200,000. This is because the tax basis is “stepped-up” to the fair market value at the time of the parent’s death.
The stepped-up basis can be a significant benefit for heirs, as it can reduce the amount of capital gains tax that they may owe if they later sell the inherited property.
If the heir sells the inherited property for a price that is equal to or less than the stepped-up basis, they will not owe any capital gains tax on the sale. If they sell the property for more than the stepped-up basis, they will owe capital gains tax on the difference between the sale price and the stepped-up basis.
How is fair market value determined?
To determine the fair market value of an asset at the time of the original owner’s death, a qualified appraiser may be hired to provide an appraisal report. The appraisal report should provide a detailed description of the property being appraised, along with an explanation of the valuation methods used and any assumptions made.
The valuation date is typically the date of the original owner’s death, although there are some exceptions. For example, if the estate qualifies for the alternate valuation date, the valuation date can be six months after the date of the original owner’s death. The alternate valuation date may be elected by the estate if the total value of the estate on that date is lower than the total value on the date of the original owner’s death.
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Step-up basis capital gains
The step-up in basis can be a significant benefit for heirs, as it can reduce the amount of capital gains tax that they may owe if they later sell the inherited property. If the heir sells the inherited property for a price that is equal to or less than the stepped-up basis, they will not owe any capital gains tax on the sale. If they sell the property for more than the stepped-up basis, they will owe capital gains tax on the difference between the sale price and the stepped-up basis.
For example, let’s say that an individual inherits a stock portfolio from their deceased parent. The value of the portfolio at the time of the parent’s death is $500,000, and the parent originally purchased the portfolio for $200,000. If the heir sells the stock portfolio for $600,000, their capital gains tax liability will be based on the difference between the sale price and the stepped-up basis, which is $100,000.
If the heir sells the stock portfolio for $450,000, they will not owe any capital gains tax, as the sale price is less than the stepped-up basis.
Pro Tip: Any sales of inherited property automatically qualifies for long-term capital gains tax treatment. It doesn’t matter when the heir sells the inherited property, it could be a year from the time of death or a month after the time of death.
Contrary to popular belief, the step-up in basis for real estate is not some loophole (by itself) to the estate tax for wealthy families to transfer wealth over generations.
Rather, it’s more of a benefit to the decedent over the course of his or her life in the form of reduced income tax liability. Think about it this way. A real estate investor who depreciates a rental property fully receives the benefit of paper losses against their income tax liability over the course of many years (i.e. 27.5 years to fully depreciate residential property).
Unless the investor utilizes a 1031 exchange, then when the investor sells he or she would normally be responsible not only for capital gains tax, but depreciation recapture at 25%. Therefore, the depreciation is technically only a temporary benefit that should be paid back when the investor sells (assuming it’s sold for more than the remaining cost basis).
However, if the investor never sells, then it’s the investor who has benefited from having had a reduced income liability for many years.
As for the heir, it wouldn’t seem fair for the next generation to be responsible for any capital gains liability from someone who’s died right?
Step-up in basis is not an estate tax loophole
When the heir receives the rental property at fair market value, they are taxed on that full market value. The fair market value of the property counts against the lifetime estate and gift tax exemption that the decedent has. So there is no free lunch or way around the estate tax, at least not via the step-up in basis alone.
Keep in mind this is actually quite fair. Only in certain select markets like NYC before 2020 could you credibly say real estate was something like a tax arbitrage, because the depreciation really was a paper loss no matter how old a property was in NYC (i.e. think an old West Village townhouse or condo that keeps increasing in value over time). Meanwhile, in other markets like South Florida, depreciation is quite real due to the lack of supply constraints, real weather related wear-and-tear, and the fact that newer is always better.
