Agent

‘Stepped-up basis’ for inherited real estate explained

Heir worries about paying capital gains tax

DEAR BOB: Recently you had a fascinating letter about a person who inherited a house. You said the heir received a new “stepped-up basis” to the market value on the date of the decedent’s death (or valuation date used by the deceased’s estate). Then you commented if the heir sells the inherited property immediately there would be no capital gains tax to pay. As I am in a similar situation, expecting to inherit several pieces of property after my terminally ill mother passes on, how soon must I sell that inherited property to avoid paying capital gains tax? – Fred R.

DEAR FRED: I was amazed at the tremendous response of letters and e-mails to that item seeking more information. If you have read my articles very long, you know I often say, “It is better to inherit property than to receive it as a gift before death.”

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The reason is the heir receives a new “stepped-up basis” of the property market value on the date of death (or alternate valuation used by the deceased’s estate). However, if a dying person such as your terminally ill mother deeds real estate as a gift, the donee takes over the donor’s usually low adjusted cost basis and does not receive the major benefits of a new stepped-up basis on the date of death.

To finally get to your question, there is no need for you to hurry to sell inherited real estate. That is because you will have a new stepped-up basis for those properties. You will owe capital gains tax only on the increased net sales price above your stepped-up basis.

For example, suppose when your mother passes on, the property she leaves to you is worth $300,000. But her adjusted cost basis was only $75,000. If she deeded it to you before her death, your basis would be only $75,000. For some unexplained reason, many dying property owners insist on deeding property to their heirs before death. This is a costly mistake for the heirs.

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Continuing our example, your “stepped-up basis” for the inherited property will be $300,000. But by the time you decide to sell that property, suppose you net $350,000 after selling expenses. Therefore, you will have only a $50,000 taxable capital gain. For more details, please consult your tax adviser.

WHAT IS “RECAPTURE OF DEPRECIATION?”

DEAR BOB: You recently said in an article that a property investor’s depreciation deducted after May 6, 1997, is “recaptured” and taxed at a special 25 percent federal income tax rate. But my accountant says I am liable from the time I first started deducting depreciation on my rental property. Who is right? – Sanford A.

DEAR SANFORD: We are both correct. On your income tax returns, when you deduct depreciation for business or rental of your real estate, that deduction must be subtracted from your adjusted cost basis of that property.

Before May 6, 1997, the tax result was your depreciation deduction was taxed when you sold that property for more than its depreciated “book value” as a capital gain. That remains unchanged for pre-May 6, 1997, depreciation deducted.

However, after May 7, 1997, any depreciation deduction is “recaptured” (which means taxed) at the special 25 percent federal tax rate. This compares with the current maximum 15 percent federal tax rate for long-term capital gains. For more details, please go to my Web site www.bobbruss.com and download my free report, “2004 Realty Tax Tips.”

READER SAYS NO GOVERNMENT LAND PATENTS ARE AVAILABLE

DEAR BOB: Your recent item labeled “cheap land” for obtaining a federal government land patent (deed) was misleading. On Sept. 30, 1994, the president signed the Appropriations Act for the Department of the Interior. This legislation contained a patent moratorium, with exceptions. Each year since then, Congress has continued the moratorium by limiting funds for processing patent (deed) applications through at least fiscal year 2005 “for a patent for any mining or mill site claim located under the general mining laws.” The latest legislation is awaiting the president’s signature – Lawrence L.

DEAR LAWRENCE: Thank you for that information for anyone who was thinking of filing a claim to government land for minerals discovered.

CAN CO-HEIR FORCE SALE OF INHERITED PROPERTY?

DEAR BOB: About two years ago, my sister and I inherited our late mother’s house. Because it is in a great neighborhood where homes are appreciating in market value like wildfire, we decided to keep it as a rental. When our tenant recently moved out, my sister said she wants to sell the house. But I don’t want to sell because the house appreciated at least 15 percent in market value in 2004 and will probably do likewise in 2005. It is a great free and clear investment. However, my sister went to a real estate lawyer who says he can force me to sell if I don’t buy out my sister’s interest. Since I don’t have that kind of cash, what can I do? – Richard S.

DEAR RICHARD: Presuming you and your sister are tenants in common, in most states a tenant in common co-owner can sue the other owner(s) in a partition lawsuit to force the sale of the property. The judge can then order the property sold with the sales proceeds divided among the co-owners.

However, you said the house is free and clear. If you want to keep the house, why not obtain a mortgage for 50 percent of the mortgage value so you can buy out your sister’s interest? Please consult a real estate lawyer for more details.

CAN NEIGHBOR BLOCK EASEMENT PATH WITH PIT BULL DOG?

DEAR BOB: Since we bought our home about 10 years ago, we have used a path across a neighbor’s backyard to reach a nearby street where there is a small shopping center and the school bus stop for our two children. Recently, the neighbor’s house was sold. The new owner has a pit bull dog and we are terrified to walk on that path. However, there is no other easy access without walking about four extra blocks. When we bought our home, we were told we had an easement over the neighbor’s backyard, and there was never any problem with the previous owner. Do we have any recourse? – Sharon C.

DEAR SHARON: Your letter brings back memories of a similar situation I had as a boy growing up in Edina, Minn. We had a very friendly relationship with our immediate neighbor who never objected to my walking through his gate, then across another neighbor’s property, to reach my best friend’s house. The mail carrier used the same gate to deliver mail to the adjoining house.

But then a new neighbor bought the non-adjacent house and he had several vicious dogs. After that, I decided to take the long way around rather than risk a dog bite. I don’t know what happened to the mail carrier.

As for your situation, I suggest you research the legal status of your path over the neighbor’s backyard. Unless you can find a recorded easement, or there was sufficient use time to establish a prescriptive easement, you probably have no legal right to continue use of that path. Please consult a local real estate attorney for full details.

$250,000 TAX EXEMPTION ONLY AVAILABLE FOR PRIMARY HOME

DEAR BOB: About five years ago, a good friend and I bought a rental house as an investment. It turned out to be very profitable. Although we just added minor fix-up, such as painting, landscaping, a new roof, carpets and light fixtures, we recently talked with the Realtor who sold it to us and she says she can get about $325,000 more than our purchase price. If we decide to sell, how does that $250,000 tax exemption you often discuss enter into the picture? – Gertie W.

DEAR GERTIE: It doesn’t. The $250,000 tax exemption (up to $500,000 for a qualified married couple) only applies to the sale of your principal residence. To qualify, you and your co-owner would have to move into the residence for at least two years before selling.

Then you can each claim up to $250,000 tax-free principal residence sale profits. More details are in my new special report, “Everything Homeowners Need to Know About the New $250,000 and $500,000 Home Sale Tax Exemption Rules,” available for $4 from Robert Bruss, 251 Park Road, Burlingame, CA 94010 or by credit card at 1-800-736-1736 or instant Internet download at www.bobbruss.com. Questions for this column are welcome at either address.

(For more information on Bob Bruss publications, visit his
Real Estate Center
).

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