Inheriting property is not the same as being gifted that property, and nowhere is that more evident than through the concept of basis. Let’s look at a simple buy and sell transaction to get a basic idea of what we are talking about. If you buy property for $1,000 and then sell it for $2,000, then you made a profit of $1,000 and that profit is taxed like income. For the sake of this example, we are ignoring the laws of how long you have to own a property to sell it, and anything to do with capital gains. This is just a simple discussion of buying and selling property to help us understand basis.
The $1,000 you used to buy that property is called your basis. When you sell the property, you figure your profit by subtracting your basis from your selling price. Basis is a term that shows up in estate planning for several good reasons, and it is something that everyone should be aware of.
The normal assumption people make is if someone gives them a plot of land that their basis is zero since they did not pay for it. But when you are gifted a piece of land, you also assume what is called a carryover basis. If the person who is giving you the property paid $1,000 for it, then that basis carries over to you and becomes your basis as well.
This idea of carryover basis is very nice if you are being gifted property that the owner possessed for a long time and the value has gone up. While it would be nice to be able to say your basis is zero and consider your selling price to be all profit, at least you know that you are starting with a low basis and can still make a nice profit when the transaction is over.
Let’s say that you bought a piece of property several decades ago for $1,000 that has since appreciated to $100,000. When you pass away, you leave that property to your children who decide to sell it for $100,000. The basis for a property when it is transferred as an inheritance is the current market value of the property. That means that your children can pocket the $100,000 and not worry about paying tax on the profit because the value of the property is $100,000.
This is one way that families allow pieces of property to become income sources for future generations. By leaving the property to future generations in a will or estate, the original owners ensure that the property can be sold at a significant profit that does not offer any tax implications. This is called a step-up basis, and it does have protections in place to prevent fraud. Each state has different rules, but most states require property to be owned by the person who has passed away for several years before allowing the basis tax break.
When you make an appointment to talk to an estate expert, be sure to discuss the topic of basis. You can use step-up basis as a way of protecting your beneficiaries from taxes that they may have had to pay if you had given them your property while you were still alive.