It’s tax time again. Last year in 2011 you sold dad’s house, which you received after dad died in 2010. Dad originally paid $5,000 for the property in the 1950s, but you sold it for $125,000, for a gain of $120,000. What is your taxable gain you must recognize and upon which you must pay taxes? The answer is, it depends mainly upon how the property is titled on the date of death.
You have heard about step-up in tax basis rule that allows you to escape taxes but what is it? How is it calculated? I have seen this rule confuse both taxpayer and tax preparer alike.
If the property was in dad’s sole name on his date of death and it came to you through the probate process or from a transfer on death deed, then your tax basis in the property is generally the value of that property on such date of death. If the home was worth $115,000 on dad’s date of death in 2010, your tax basis is $115,000. When you sold it for $125,000 in 2011, you only have to pay taxes on a gain of $10,000, which is just the increase from the date of death value of $115,000 to the sales price of $125,000. The $110,000 gain from dad’s original purchase price of $5,000 to the date of death value of $115,000 completely escapes all taxes. Great result.
If instead of the home being transferred after dad died, dad gifted the property to you in 2002 by quit claim deed into your sole name. This would cause a different result. Your tax basis in the property would be dad’s basis in the home of $5,000. This is called carryover basis. When the dad’s home sold for $125,000 in 2011 after dad’s death, you would then have pay capital gains taxes on the entire $120,000 capital gain. Bad result.
There is a special rule for gifted property you sell for a loss. Your basis is the lesser of the carryover basis or the fair market value on the date of gift. This prevents mom or dad from transferring the loss to you by gift.
These basis rules apply to just about any assets that are not held in an income tax advantaged financial account such as a retirement plan or IRA. These types of financial accounts have pre-tax dollars in them that have never been income taxed. Because of this, neither the step-up in tax basis rule nor the carryover basis rule applies to these accounts after a death.
When you withdraw funds out of these income tax advantaged accounts after dad’s death, they are taxed to you as ordinary income, just as they would have been taxed to dad if he would have drawn them out during their lifetime.
Another situation in which the tax basis rules confuse many is joint ownership. If dad added you as a joint owner of his property, there is a different income tax treatment to you depending upon whether the property is sold before or after his death.
If that joint property is sold during dad’s lifetime, you and dad would each calculate your taxable gain on the sale of the property using one–half dad’s original carryover basis. There typically is no step-up in basis for these types of gifts when they are sold during the original owner’s lifetime. Using dad’s basis of $5,000 and a sales price of $125,000, you both would report $60,000 taxable gain. Bad result.
On the other hand, if the joint property was not sold until after dad’s death, you would receive a full step-up in basis of that property to the value on dad’s date of death. But there are certain requirements for this to occur. If dad was the original purchaser of the property, you contributed nothing to the purchase, and dad retained an interest in the property at the time of his death by still having his name on the deed with you, you would get that full step-up in tax basis after mom or dad died. You would only pay capital gain income taxes on the increase in value after his date of death. Using the figures from our original example above, you would only report a taxable gain of $10,000. Another great result.
The step-up in basis rule is a little different with joint ownership between a husband and a wife. It does not matter which spouse contributed to the purchase of the property. For property that is held jointly by a husband and wife, each spouse is deemed to own one-half of the property. Upon the death of one spouse, the surviving spouse gets a step-up in basis in the half received from the deceased spouse and a carryover basis in his or her own half. If their original cost was $5,000 and the value at Dad’s date of death was $115,000, Mom’s tax basis in the property to determine her taxable gain when she sells it, would be $60,000. This is determined using one-half of the $5,000 original basis or $2,500, plus one-half of the $115,000 date of death value or $57,500.
Some people think that this step-up in tax basis rule causes life insurance to be income tax free to the beneficiaries when paid after death of the insured. While it is true that the proceeds of most life insurance policies are income tax free to the beneficiaries, this has nothing to do with the step-up in tax basis rule. This is just a special tax code provision. Although life insurance proceeds are generally income tax free, they are not always estate tax free.
Do not try this type of planning on your own. Before adding any of the kids to your deed to your home, consult with your tax advisor and your estate planning attorney to determine the best course of action regarding your entire family tax liability and the result you want to accomplish.
By: Matthew M. Wallace, CPA, JD
Published edited April 15, 2012 in The Times Herald newspaper, Port Huron, Michigan as: Understanding the ‘escape’ clause