REAL ESTATE STEPPED UP IN BASIS

By James W. Mallonee

Did you know that when you die your permanent property (where you call home) receives a step-up in basis in an effort to avoid capital gains taxes. This avoidance prevents the decedent’s estate and its beneficiaries from being taxed as a gift or income. This is also true for stocks and bonds and other property which you are passing to the beneficiaries of your estate. The exception to this rule is an IRA and 401K which receive no step-up in basis. By receiving the step-up in basis for property, the Federal capital gains tax can virtually be avoided.

Generally speaking, a step-up in basis occurs when you purchase property for $100.00 and twenty years later that same property is worth $500.00. At your death, that same property gets a step-up in basis as it passes to your beneficiaries. Your beneficiary receives that property with a value of $500.00. If the property is sold immediately for $500.00 following your death, the gain in the property is $0.00. As a result, a capital gain does not occur and thus no taxes are paid. On the other hand, should the decedent sell the property for $500.00 prior to his or her death, the decedent would have to pay the taxable amount due on the $400.00 gain. By waiting until death to pass the property to a beneficiary, the “stepped-up basis loophole” is put into action.

However, there is a proposed change on the horizon to close the “step-up in basis loophole” that has been enjoyed by all American’s who pay taxes or transfer their property to their beneficiaries at death. The proposed changes would affect transfers at death where the asset has appreciated and the appreciated value is what would get taxed. Naturally, there would be some exclusions between spouses and charities. In the event that there is no surviving spouse, the decedent’s estate would be responsible for the tax on the gain. (NOTE: Canada citizens have something very similar to this proposal).

So, what is the reason for changing the tax code; to remove the most expensive “gaps in the tax base.” Our legislators point to: 1) lack accuracy in measuring vertical and horizontal equity of property; 2) the stepped up basis tends to create a lock in effect; and, 3) a loss of tax revenue. The lack of accuracy is directed to those individuals with a high net worth who have made investments that have gained in value as opposed to those individuals who either did not or could not afford to make such investments. Those high-net-worth individuals are simply passing the gains to the next generation without paying their share of the tax burden for the increase in an asset’s value.

The lock in effect is affectionately described as keeping assets (good or bad) in order to take advantage of the step-up in basis and avoid paying capital gains. Thus, a person’s decision-making is being impacted on whether to pay an increased income tax or just wait until death to pass the property and avoid the tax consequences of selling property while alive. In essence, the beneficiary can take the property and sell it immediately and avoid paying the associated income tax.

Our legislators are stating that we are losing close to 50% of the possible taxes that could be earned if the step-up in tax basis were eliminated. If the step-up in basis is so one sided, why is the elimination of the step-up in basis now becoming such an issue? The answer seems to be that there is no simple solution to the problem. Examples include family farms or closely held businesses. What about those assets which decline in value immediately following the death of the owner? These are all issues that need to be reviewed before implementing such major changes.

The real issue at hand will be the American public’s willingness to accept such changes, especially given the current political and economic environment. If you find yourself at the crossroads of a parent or relative’s death, you’ll be glad to know of the stepped-up basis when it involves real estate that increased in value by 100 percent. You won’t have to pay income taxes on the inheritance (at least not in Florida and to the IRS).

This article is intended for informational use only and is not for purposes of providing legal advice or association of a lawyer – client relationship