Are you familiar with capital gains? That is, the difference between the purchase price of an asset and the sales price. The IRS requires you to pay taxes on all of your capital gains. There is a special rule for inherited property, however. This rule is referred to as “step up in basis,” and it provides a very valuable tax break.
How does the “step up in basis” work?
Let’s say, for example, that you inherited a house from your grandmother. When she bought the house in 1980, she paid $80,000 for it. At the time of her death, the home is now worth $350,000. Now, if you decide to sell the house later on, your basis will be $350,000. In other words, if you sell it later for $375,000, you will only be taxed on the difference between the value when you inherited it ($350.00) and the amount you sold it for, or $25,000.
Mistakes that could jeopardize your step up in basis benefits
Although the step up in basis rule seems pretty straightforward, there are mistakes that you need to avoid in order to take full advantage of this tax-saving rule. Two of the most common mistakes are (1) owning your home with your children, and (2) holding the title of your home in joint tenancy with your spouse.
Joint ownership with your children
The best thing to do, when you want your children to inherit your home, is to transfer the home to a living trust, which will pass the home on to your children at your death. Joint ownership with your children is not the way to go. Why? Because, if your children own the house with you, they will not be able to use the “step up in basis” rule, but instead, will be taxed on the capital gains for the full appreciation of the property.
Joint-tenancy ownership with a spouse
The same is basically true for holding the title of your home in joint tenancy with your spouse. The surviving spouse will retain the original cost basis, as opposed to the step up in basis that would otherwise be available. Also, there is a chance that a potential “step up” could instead be a “step down” if the value of the home has dropped at the time of your death. Therefore, it is important to consider the market value of your assets, and make necessary adjustments.
Preserve this valuable tax break
The step up in basis rule may be one of the largest tax breaks provided by the IRS, when it comes to assets that have appreciated substantially. It would be an awful waste to forfeit the valuable benefits, the step up in basis rule provides, by making mistakes that could easily be avoided. The best thing you can do to preserve this benefit, is to discuss your options with your estate planning attorney.
If you have questions regarding asset appreciation, step up in basis, or any other estate planning issues, please contact the Schomer Law Group either online or by calling us at (310) 337-7696.