Stepped up value or cap gains?

[Stephen1]

How will this work under today's tax rules?
If I still own this property when my wife and I die will the heirs get a stepped up value? Or will someone have to compute the capital gain?

Bought house in 1978.
Lived in it until 1980.
Rental from 1980 - 1986.
Lived in it for a year ('86-'87).
Again a rental until 1995 when it was part of a Starker exchange for another rental.
Still own that rental gained in the exchange.

 

[Taxing Matters]

How will this work under today's tax rules?
If I still own this property when my wife and I die will the heirs get a stepped up value? Or will someone have to compute the capital gain?

I won't get into all the details of it because how you own the property with your wife and sequence of when you and your wife die will affect the basis the beneficiaries get. However, the general answer to your question is that when you die owning property that you had used as a rental the basis for the beneficiary will be determined by taking the fair market value of the property less the amount allowed to you as deductions for depreciation on that property. Thus if the beneficiary promptly sold it for fair market value he or she would indeed have a gain on the sale of the property.

 

[LdiJ]

How will this work under today's tax rules?
If I still own this property when my wife and I die will the heirs get a stepped up value? Or will someone have to compute the capital gain?

Bought house in 1978.
Lived in it until 1980.
Rental from 1980 - 1986.
Lived in it for a year ('86-'87).
Again a rental until 1995 when it was part of a Starker exchange for another rental.
Still own that rental gained in the exchange.

Yes, your heirs would get a stepped up basis. It doesn't matter whether or not it was a rental. If they inherit it from you, it gets a stepped up basis. You cannot however, give it to them ahead of your passing. If you do that, they get your basis in the property rather than a stepped up basis.

 

[Taxing Matters]

Yes, your heirs would get a stepped up basis. It doesn't matter whether or not it was a rental. If they inherit it from you, it gets a stepped up basis. You cannot however, give it to them ahead of your passing. If you do that, they get your basis in the property rather than a stepped up basis.

The depreciation taken on the rental has to be subtracted from the stepped up basis, as I indicated in my previous answer (which I know you likely did not see before you posted yours given the timing of the posts).

 

[FlyingRon]

Really? I was under the impression that death stepped up the basis and wiped out the depreciation recapture. In addition, the heir can start depreciating all over again (if they qualify) based on the new stepped up basis.

 

[LdiJ]

The depreciation taken on the rental has to be subtracted from the stepped up basis, as I indicated in my previous answer (which I know you likely did not see before you posted yours given the timing of the posts).

I just ran this by a co-worker who specializes in real estate taxation and we are both confused by this, and frankly neither of us has heard of it. How would someone who inherited a house necessarily have the information to know what depreciation would have been allowed or allowable on prior year tax returns for the deceased, and doesn't this defeat the whole purpose of a stepped up basis?

I googled the subject and on at least a dozen different websites it specifically states that you get a stepped up basis and do not have to be concerned with recapturing depreciation taken on the deceased prior tax returns. So if my co-worker and I have it wrong, so do a whole lot of other tax professionals.

My co-worker in particular would like to know if you could you point us in the right direction to do further research?

 

[davew9128]

I won't get into all the details of it because how you own the property with your wife and sequence of when you and your wife die will affect the basis the beneficiaries get. However, the general answer to your question is that when you die owning property that you had used as a rental the basis for the beneficiary will be determined by taking the fair market value of the property less the amount allowed to you as deductions for depreciation on that property. Thus if the beneficiary promptly sold it for fair market value he or she would indeed have a gain on the sale of the property.

I'm sorry but this simply isn't true. There is nothing in IRC 1014 which reduces basis adjustments at date of death based on the use of the property or any depreciation claimed by the decedent before death.

 

[Taxing Matters]

I'm sorry but this simply isn't true. There is nothing in IRC 1014 which reduces basis adjustments at date of death based on the use of the property or any depreciation claimed by the decedent before death.

After rereading section 1014, I agree. The reduction in basis for depreciation occurs only if the the property involved was received by the beneficiary before death and then dragged back into the decedent's estate for purposes of the the federal estate tax. A rather uncommon event. See IRC § 1014 (b)(9). It was that provision I had in mind when I answered the question. I apologize for the error.

 

[LdiJ]

As a recap for Stephen:

We are now all in agreement that your heirs will get a stepped up basis when they inherit the house from you. They will not have to recapture depreciation. You must not give it to them in advance of your passing.

 

[Stephen1]

Thank you all. So, right now I'm thinking the plan will be to hold on to the property (or do another Starker exchange). Depending upon how onerous continuing to be a landlord will be that it may be simpler than selling and trying to compute the capital gains.
The depreciation isn't a big issue as my wife is a bookkeeper and has that down to the penny (at least I believe she does). Now, for closing costs on the original purchase and capital improvements on the original house I'm at a slight loss 'cuz some of that (e.g. new roof) was done when we were living in it and it wasn't a rental. I went looking for the records on that and am having some trouble finding them. Not sure that IRS likes 'best guess'.

 

[Taxing Matters]

Thank you all. So, right now I'm thinking the plan will be to hold on to the property (or do another Starker exchange). Depending upon how onerous continuing to be a landlord will be that it may be simpler than selling and trying to compute the capital gains.

Just don't let the capital gains issue be the sole driver in your decision. It can sometimes be worth taking the capital gains hit (which would be no more than 20% of the gain and might be less than that depending on income) plus potentially some gain taxed at ordinary rates for depreciation recapture to cash out and use the money for some other more worthwhile investments.