How to Calculate the Basis of Estate Property?

Understanding the Basis of Estate Property: Key Considerations for Heirs

In estate planning, one critical concept that heirs must understand is the basis of property inherited from a decedent. The basis of the property plays a significant role in determining the taxable gain or loss when the property is eventually sold. This blog will explore the rules governing the basis of estate property, with a focus on how these rules impact the taxation of inherited assets.

The Basis of Inherited Property: Key Options

The basis of property inherited from a decedent is generally determined by one of the following methods:

1. Fair Market Value (FMV) on the Date of Death: Typically, the basis of inherited property is its fair market value on the date of the decedent’s death. This means that the property’s value is “stepped up” (or down) to its current market value, which is the most common method used.

2. Alternate Valuation Date: The personal representative of the estate may elect to use the FMV on an alternate valuation date. This date is generally six months after the date of death. However, this alternate value can only be used for assets that are still part of the estate and have not been distributed to heirs or sold within those six months. The election of this method must be made by the personal representative and can offer tax advantages in certain circumstances.

3. Special-Use Valuation for Real Property: If the estate includes real property used in farming or a closely-held business, a special-use valuation method may be applied. This method allows the property to be valued based on its actual use rather than its highest and best use, which can result in a lower estate tax valuation.

4. Decedent’s Adjusted Basis in Land: In some cases, particularly when dealing with land subject to a qualified conservation easement, the decedent’s adjusted basis may be used to the extent of the value excluded from the taxable estate.

Example: Applying the Basis Rules

To better understand these rules, consider an example:

James, who is unmarried, passes away on March 3, 2023. At the time of his death, he owned a house in San Francisco, which he had purchased in 1964 for $35,000. James lived in the house continuously since its purchase. The fair market value of the house on the date of James’s death was $2,500,000. His daughter, Emma, inherits the house as the sole beneficiary.

Since the house was the only significant asset James owned, no estate tax return needs to be filed. The basis of the house for Emma would be the FMV at the date of James’s death—$2,500,000. A month later, Emma sells the house for $2,510,000. The taxable gain on the sale would be just $10,000 (the difference between the stepped-up basis and the sale price). This gain would be taxed at favorable long-term capital gains rates, significantly reducing her tax liability compared to what it would have been if the basis were not stepped up.

Jointly Owned Property and Step-Up in Basis

Property jointly owned by the decedent and another person will generally be included in the decedent’s gross estate, unless it can be demonstrated that the other owner contributed to the purchase price. The surviving owner’s new basis in the property will be the sum of their original basis plus the portion of the property’s value included in the decedent’s estate.

For example, if property is jointly owned by a husband and wife as tenants by the entirety or as joint tenants with the right of survivorship, only one-half of the property’s value is included in the gross estate, and there is a step-up in basis for that one-half. In community property states, however, the entire property receives a step-up in basis, providing an even greater tax advantage.

Conclusion

Understanding the basis of inherited property is crucial for heirs, as it directly impacts the potential tax liabilities when the property is sold. By knowing how the basis is determined and the options available, heirs can make informed decisions that minimize taxes and preserve more of the estate’s value. Whether dealing with real estate, investments, or other types of property, being aware of these rules can lead to significant tax savings.

As always, consulting with a tax advisor or estate planning professional is recommended to navigate the complexities of the tax code and to ensure that the estate is managed in the most tax-efficient manner possible.