A step-up in basis can save you a lot of money at tax time. The term relates to income and capital gains taxes and can save you a considerable amount of money should you ever decide to sell an asset or property that you've inherited.
When you receive property through a will or inheritance, the Internal Revenue Service (IRS) assesses taxes by assigning a value to the property based on its current market value—called the basis. Learn how a step-up in basis helps reduce income or capital gains taxes you might owe from inheriting and selling property.
Step-Up in Basis
The IRS defines basis as the value of a property used for tax purposes. When you legally inherit property, you might have to pay inheritance taxes, depending on the state you live in. Capital gains or income taxes are only triggered if you sell the property after inheriting it.
For inherited property, income and capital gains taxes are calculated based on the property's fair market value, including the cost of any capital improvements you've made. You'll pay taxes on the difference between the sales price and your basis when you sell the property. If the property has lost fair market value when you sell it, you'll have experienced a capital loss.
Step-up in basis can be used for all inherited assets—stocks, bonds, real estate or any other property of value.
Your basis in inherited property is not what the decedent initially paid for the asset. It's automatically "stepped up" to the asset's current market value at the time of their death, which makes a big difference if the value has significantly increased.
Inherited Property and Taxes
Capital gains are classified as either short-term or long-term. If you sell the house within a year of taking ownership, it is a short-term gain and is taxable as ordinary income.
If you hold the house longer than one year, you could pay up to 15% in taxes if you earn between $80,000 and $441,450 (single) or $496,600 (joint). If you make more than either of the upper limits, you could pay up to 20% in capital gains. But if you earn less than $80,000 per year, you'll likely pay no capital gains taxes on the property.
The home sales tax exclusion rule applies if you occupy the inherited house.
If you inherit real estate and live in it for at least two years before selling it and are single, you can exclude up to $250,000 in capital gains without paying taxes on it.
If you're married and file jointly, you can exclude the home for up to $500,000 in gains without being taxed. To get the exclusion, you must use it as your principal residence.
Coupled with the step-up in basis on your father's property that reduced your gain to $50,000, you would owe no capital gains tax at all as long as you lived in the property for at least two years.
A Step-Up in Basis Reduces Taxes
Here's an example—your father lived a long life and recently passed. In his will, he left his house to you. He paid $50,000 for the house 30 years ago. You don't want to live in the home or go through the hassle of renting it out, so you put it up for sale.
You can use step-up basis and capital gains tax rates to lower your tax obligations on inherited property.
You sell the house one month later for $400,000. Under standard tax rules, you would owe income tax on the $350,000 positive difference without a step-up in basis if you made less than $80,000 that year. Using the stepped-up value of $350,000, you only made $50,000 on the house—you reduced your tax burden significantly.
This is how a stepped-up basis provides tax benefits—it can reduce the amount of taxes you have to pay on inherited property. It can even reduce the amount you owe to zero.