Monday, March 23, 2015

Happy Birthday from the IRS! (Stepped-Up Basis)

What is stepped-up basis?

When you inherit a house (or anything other than an IRA or 401(K)), you get stepped-up basis.  What is stepped-up basis.  For that matter, what is basis?

When you sell something, your profit is determined by the "Amount Realized" (AR) minus the "Basis" (B).

The "Amount Realized" or AR is usually the sale price, or what you realized from the sale.  When you sell something, we call this, in tax terms, a "realization event".

The "Basis" or B is usually the amount you paid for the item.   But not always.

Thus, if you buy a little red wagon for $5, your "Basis" in the wagon is $5.  When you sell it for $7, your "Amount Realized" or AR is $7.

Thus, your "Gain" or G (sometimes called "profit") is:

G = AR - B

G = 7 - 5

G = 2

OK, that was simple enough, right?  You buy a little red wagon for $5 and sell it for $7 and make a profit or Gain of $2.

So what is "Adjusted Basis" and "Stepped-Up Basis" all about?

Well, under our tax laws, for the purposes of calculating taxes, we can "adjust" the basis in an item, based on a number of factors.  The most common is depreciation.

You buy an apartment building for $1M and rent it out for 10 years.  Each year, you "depreciate" the building by deducting 1/10th of the value of the building on your taxes (for actual numbers, see your tax adviser).   Why?  Don't ask questions, just take the deduction.  So over the years, you've deducted $100,000 each year from your income, which knocks down your income tax pretty good.

Four years later, you sell the apartment building for $1.3M.   What is your "Adjusted Basis" (AB)?   Well, 4x $100,000 = $400,000.   So your "Adjusted Basis" is the purchase price ($1M) minus the depreciation ($400,000) yielding $600,000.

Thus, if you sell the building for $1.3M (AR) and your "Adjusted Basis" is $600,000, then your gain G is:

G = 1,300,000 - 600,000 = 700,000.

As you can see, your "gain" is not a mere $300,000 for tax purposes, but a whopping $700,000, at capital gains rates (not ordinary income rates).   So you see, you can play games with this, and cut your ordinary income taxes (taxed at 39%) and pay at capital gains rates (15-25%) through the miracle of depreciation.

Note that you are not  forced to take the depreciation deduction but it usually is a better deal.

But what does "stepped-up basis" mean?

If you inherit a house then the "basis" in the house is what the value was at the time of death of the testator.

So Mom and Dad die and leave you their house.  They paid $75,000 for it back in 1980 and today it is worth $500,000.  Do you owe any taxes?

Hell no!   Isn't it great to live in America?

Your basis is "stepped up" to the value of the home at the time of death, and when you sell the home, you take home $500,000 tax-free.   Oh, so sweet to be middle class, no?  Rich folks, on the other hand, have to worry about the Gifts and Estates tax, which kicks in at $5M or so.

Recently, we came into a small inheritance, as a relative died and we sold their house.   The house was transferred to Mark and his siblings in 2005 when his Dad died.  His stepmother had a "life estate" in the house, and she died last year.

None of us thought about it at the time, but the "stepped-up basis" of the house was the value back in 2005 (when the market went berserk)  and the "Amount Realized" was the much lower price we received in December 2014, when the house was sold.

This amounts to a loss of well over $100,000, depending on how you calculate the basis value in 2005.  Yes, there are appraisers in Florida who will do an "historic appraisal" for you, if you request it.

So what does this mean?   Well, I am glad we did not file our taxes yet, as Mark now has at least a $45,000 capital loss to add to his taxes, which should wipe out most of his annual income, which means the $5000 I paid in income taxes to the IRS and the $1500 to the State will likely be refunded in total.

UPDATE 2020:  You may not be able to take all of the deduction in one year.  Instead, we were forced to take the deduction over several years as a "carry-over loss".  Consult your tax adviser for details - for this and all other matters!

So in this instance, not only is the inheritance tax free but since it was inherited at the height of the real estate boom, it is a tax deduction as well.

Of course, that sounds all fine and well and all, but if we could have sold the house in 2005, we would have realized a lot more money that in the tax deduction.   But the point is moot, since the stepmother had a life estate, we could not sell the  house.
And it also illustrates that you cannot deduct your way to wealth.   While you should take every deduction possible, usually the thing that triggers the deduction is far more valuable or costly than any possible tax savings.

But anyway, it was a nice birthday present from the IRS.