When considering leaving property to beneficiaries, tax considerations factor heavily in estate planning. Since one is hard pressed to find any aspect of our life (and death) that is not subject to some form of taxation, it should not come as a surprise that the Tax Code contains some very particular regulations as to the taxation of assets passed down to beneficiaries through an inheritance.
One area in the Tax Code estate planners should pay particular attention to is the way in which the IRS assesses the tax value of inherited property. For example, one may ask how the IRS calculates the taxable value of property transferred from a benefactor to a beneficiary. The short answer to this question is that it depends on when the property is transferred.
The Stepped Up Basis
Under normal circumstances the, IRS will calculate the value of property for tax purposes according to what it refers to as the “tax basis” or the amount a person has invested in an asset. For example, the cost basis of a parcel of real estate purchased in 2010 for $36,000, would still be $36,000 in 2016. Therefore, if a person receives property as an Inter Vivos Gift (between the living), the tax basis is whatever the donor’s tax basis was. As an example, a man gifts a house to his nephew that he paid $50,000 for in 1980. The tax basis will be $50,000 even if the fair market value in 2016 is $200,000. If the recipient of the gift sells the house after receiving it as a gift, for $200,000 the taxable gain on the sale is $150,000 ($200,000 minus $50,000).
However, the question of taxable value changes when the property is passed to a beneficiary through an inheritance rather than as an Inter Vivos. Using the example above, let us assume that instead of gifting the house during his lifetime, the house was transferred from the man to his nephew after his death. Once the property becomes an inheritance rather than an Inter Vivos gift, the IRS calculates the tax basis of the asset differently.
The tax basis of inherited property is the fair market value of the property at the time of the decedent’s death or as it is otherwise known as the “stepped-up” basis. In the previous example, the tax value of the house received as an inheritance would be $200,000. The impact of the stepped-basis method of valuation comes into play when a beneficiary sells property they inherit. Therefore, if the beneficiary who received the house from his uncle’s estate later sold the house for $225,000 he would be left with a table gain of $25,000. Whereby if he had sold the house after he received it as an Inter Vivos gift from his uncle he would be exposed to tax liability on a $175,000 gain ($225,000 minus $50,000).
The stepped-up basis can provide tax relief for estate beneficiaries when they later sell inherited assets. However, the calculation of an asset’s tax value can involve many factors that impact its calculation. In addition to an asset’s tax basis, it is also important to consider potential inheritance tax liability. Therefore, it is important to consult counsel experienced in estate planning to consider the tax implications of estate planning strategies.
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