Real estate owners buy real estate hoping to accumulate and build wealth for themselves and their families. However, some real estate owners are not aware of the biggest tax loophole when it comes to passing their real estate wealth on to their families.
The most famous tax loophole for real estate owners is the “stepped-up basis”. When you inherit a house, the current IRS tax code gives you a stepped-up basis in cost. Your stepped-up basis is the market value on the date of your benefactor’s death. This taxpayer-friendly rule allows heirs to sell the house they received and owe nothing to the IRS. Most real estate investors or owners want to make sure their families are financially taken care of if they die. Often times, they might need to decide whether to give certain real estate to various members of the family. This situation is common when one is advanced in age or has a terminal illness and has to decide whether to give the real estate property to their love one while they are still alive or give it away after they die. The tax consequences are tremendous depending on which route he/she chooses to take.
Let’s looks an example: Mom bought the house 30 years ago for $100,000 and fortunately, the house is now worth $1 million dollars. If mom were to give the house to her daughter while she is alive, then the daughter’s cost basis in the house is $100,000 and if the daughter sold the house for $1 million dollars then the daughter would pay capital gains on $900,000. Let’s assume that the daughter’s combined capital gain tax rates between State and Federal is 20 percent. Then the daughter would need to pay about $180,000 in capital gain taxes. However, if mom decides to hold on to the house and gift the property to her daughter in a will or a living trust upon her death then the magic of the stepped-up basis kicks in. Because the stepped-up basis magically allows the daughter to “step up” her cost basis to $1 million dollars, she would pay ZERO income taxes to the IRS. This is the only time that the IRS will forgive you for any capital tax gain. The stepped-up basis works for both principal residence and rental property.
Rental Property Stepped-Up Basis
If the daughter receives a rental property at Mom’s death valuing at $2 million dollars and mom bought it for only $1 million dollars, what is the daughter’s cost basis? The answer is $2 million dollars. If the daughter sells it for $2 million she would not pay any taxes. Our mom, in this example, is a very savvy real estate investor and like all savvy real estate investors, she is very familiar with the advantages of taking deprecation expense to offset any rental income and other income to pay lower taxes. Let’s say mom had fully depreciated this particular rental property. Mom had thoroughly enjoyed and depreciated $800,000 of this rental property. Meaning mom had taken $800,000 of depreciation expenses on this property. Now the question is: Does our daughter have to recapture and pay the IRS back for the $800,000 of depreciation expense that mom took? Meaning, can our daughter depreciate the entire cost of the building again? The answer is yes, which means we can take the depreciation expenses TWICE! It is all legal due to the stepped-up basis rule. Thus, if you have rental properties, it is important NOT to give them to your children while you are alive.
Understanding the stepped-up basis is important in terms of leaving more of your real estate wealth that you have accumulated during your life time to your heirs.