Armed with your estimated “adjusted sales price” from which you subtract your “adjusted cost basis” to arrive at the estimated long-term capital gain if you sell the property, it’s time to consider how to avoid paying capital gain tax on that sale profit.
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METHOD #1 – IF YOU INHERITED PROPERTY, DON’T FORGET YOUR “STEPPED-UP BASIS.” This is a major tax benefit of inheriting property, which most homeowners and investors don’t fully understand. Obviously, the higher a homeowner’s or investor’s adjusted cost basis in their real estate, the lower the potential capital gain when that asset is sold. “Stepped-up basis,” available only to heirs who inherited real estate and other assets, is an often-overlooked method of maximizing the adjusted cost basis for an inherited property.
FIRST RULE: Any capital gain the deceased owner would have incurred upon selling a property before his or her death is forgiven or forgotten by Uncle Sam! This is a major reason why property owners usually should NOT make a taxable sale of their capital assets if they know they are expected to die soon. Unless the property must be sold by the terminally ill owner to pay bills, or for other valid reasons, it is usually best not to sell and to thereby save the capital gain tax.
SECOND RULE: A person who receives title to a property as a gift from a property owner before death takes over that donor’s old (usually very low) adjusted cost basis and does not receive a new stepped-up basis, which only applies to inherited property.
THIRD RULE: The person who inherits a property after the decedent’s death does not take over the decedent’s adjusted cost basis but, instead, receives it with a new “stepped-up basis.” This rule also applies to a surviving joint tenant or tenant by the entireties who receives ownership as a surviving co-owner.
The new stepped-up basis for inherited assets is usually the property’s fair market value on the date of the deceased owner’s death. Or, if the deceased’s estate used an alternate valuation date several months later, that value becomes the heir’s new stepped-up basis. Special valuation rules often apply to farms and closely held businesses, or if a qualified conservation easement is involved.
Heirs should have inherited property appraised shortly after receiving title to establish their new stepped-up basis. If you inherited property many years ago and have no evidence of your stepped-up basis, hire an experienced licensed appraiser to appraise the property’s fair market value as of the date you received title. Such an appraiser is often expensive, but it is well worth the cost because the appraisal establishes your stepped-up basis to save future capital gains taxes when you decide to sell or trade the inherited property.
If the deceased’s non-exempt total net estate exceeds the federal estate tax exemption below, the estate will have paid any federal estate tax due on the inherited property before title is transferred to the heir. Surviving spouses should be aware that all assets left to a surviving spouse by the deceased spouse are free of federal estate tax under the marital exemption, regardless of total estate value. Here are the federal estate tax exemptions for decedents dying in:
Congress is expected to “adjust” the federal estate tax exemption for decedents dying in 2011 and thereafter. Under current estate tax law, if you want to leave a huge estate to your heirs completely free of federal estate tax, the obvious year to die is 2010!
When an heir receives property title by survivorship or by inheritance, the heir’s adjusted cost basis is stepped up to market value on the date of death (or alternate valuation date used by the estate). That’s usually not a problem. However, if a property owner instead gave away title to their property before death as a lifetime gift, then the donee takes over the donor’s (often very low) adjusted cost basis.
EXAMPLE: A friend or relative knows he or she is dying of a terminal disease. That person wants you to own his/her home, which is now worth $400,000 but cost the owner only $100,000 many years ago. Before death, that owner gives you a quit claim deed to the home. As the donee, you therefore take over the donor’s low $100,000 adjusted cost basis. However, if the owner had instead willed the home to you, or left it to you in his or her living trust, you would receive a $400,000 stepped-up basis. Then if you sell it for $400,000, you would not owe any capital gain tax. However, if you received the home as a pre-death gift, your basis will be the donor’s low $100,000 basis so if you then sell the house for $400,000 you will have a $300,000 capital gain.
For this reason, I frequently say it is better to inherit real estate and other capital assets with a new stepped-up market-value basis than to receive title as a gift before death. To avoid probate costs and delays, yet give the heir a new stepped-up basis, a savvy property owner should deed the title to his/her home and other real estate before death into their revocable living trust, which will then distribute it after death.
When the principal or trustor dies, his/her living trust then becomes irrevocable. The living-trust assets are then distributed after death without probate by the named successor trustee. If the living trust specified that you are to receive title to the home, the successor trustee then distributes the living-trust assets without probate to whomever is named in the living trust.
Probate costs and delays are thereby avoided and the new owner also receives a new stepped-up basis of market value on the date of the decedent’s death.
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